The FOMC’s latest forecast (June 2016) puts the fed funds rate at 0.875% by the end of 2016. The Fed will provide a new set of dot plots this week. As of September 19, the market (according to fed funds futures) puts the fed funds rate at around 0.50% by the end of 2016 [Figure 2], not fully pricing in even one 25 basis point (0.25%) rate hike this year. The latest dot plots (released in June 2016) had put the fed funds rate at 1.625% at the end of 2017, while the market says it will be less than half of that, at around 0.70%. The Fed’s June 2016 dot plots put the fed funds rate in the long term at 3.0%, down from 3.5%. As noted in Figure 3, the FOMC’s view of the long run fed funds rate has moved substantially lower over the past four years, as both economic growth and inflation have come in below their forecasts. The debate over the proper level for the “neutral” fed funds rate—among FOMC participants, and between the market and the Fed—is likely to persist well beyond this week’s meeting. On balance, we believe the FOMC will continue to lower its “dot plot,” forecasts for 2017, 2018, and perhaps even the “long run” to soften the blow of a rate hike later this year, but not by much.
How that gap closes—between what the market thinks the Fed will do and what the Fed is implying it will do—against the backdrop of what the Fed actually does will continue to be a key source of distraction for markets in 2016.
DOES THE FED CHANGE MONETARY POLICY IN AN ELECTION YEAR?
It often has and may do it again, despite misconceptions the Fed stands down before major elections. Although the Fed often pauses in the month or so prior to the November election, the Fed has changed policy (either raised or lowered rates or stopped or started quantitative easing [QE]) in every election year since at least 1968. We do not expect anything different in 2016, if conditions in the economy and labor force warrant a move. If the data called for a move at this week’s meeting, the Fed would likely act. However, the Fed would likely not raise rates at the November 2 FOMC meeting, which is less than a week ahead of Election Day on November 8. The final FOMC meeting of 2016 is on December 13–14, and our view is that the Fed considers that a “live” meeting; the fed funds futures market agrees, currently pricing in about a 55% chance of a hike at the December 2016 FOMC meeting.
WILL GLOBAL ECONOMIC AND FINANCIAL CONDITIONS GET A MENTION THIS WEEK?
Until Fed Chair Yellen’s speech in late August 2016 at Jackson Hole, a mention of “global economic and financial conditions” made it into every FOMC statement and was part of every one of her major speeches. However, Yellen left this phrase out of her Jackson Hole speech, leading some market observers to speculate that this was a precursor to a Fed hike as soon as this meeting. While financial stress has ebbed from where it was at the start of 2016 [Figure 4], financial conditions have tightened in the past few weeks and remain tighter than they were prior to the Fed’s first rate hike in this cycle in mid-December 2015. We expect the FOMC statement and Yellen’s prepared remarks may omit the reference to global economic and financial conditions, but Yellen is likely to be asked about the topic during the press conference.
WILL THE FOMC HINT AT A DECEMBER RATE HIKE?
We continue to expect that Yellen and the FOMC will stress that future rate hikes are dependent on the economy, labor market, and inflation tracking toward the FOMC’s forecasts. Looking back, in its October 2015 statement the FOMC did acknowledge it was determining “whether it will be appropriate to raise the target rate” at its next meeting. And in fact, the Fed did raise rates at its next meeting in December.
The inclusion of this type of language in this week’s statement would signal to the markets that the Fed is leaning toward raising rates at the December meeting. However, in our view, any such move would be heavily dependent on the U.S. data released between now and mid-December, and on global financial market stresses caused by the U.S. dollar, China’s bad debt problem, the ongoing negotiations around Brexit, a major terrorist event, or even the U.S. election, remaining relatively muted. We continue to expect that the Fed will raise rates in December 2016.
John J. Canally, Jr., CFA, is the chief economic strategist at LPL Financial.