This week all eyes are on the US Federal Reserve’s policy meeting for several reasons. It will be the first meeting presided over by new Fed Chairman, Jerome Powell. It is also widely expected that the meeting will deliver a 25bps hike in the Federal funds rate to 1.75%. There is also increased uncertainty surrounding how the Fed may tweak its forecasts of economic growth and inflation. For the first time in the current US growth cycle there is some likelihood that the Fed might hint that the pattern set last year of three well-spaced 25bps rate hikes in a calendar year and previously heralded for 2018 as well may not be enough.
At this stage, it is fair to say that financial markets are relatively relaxed running towards the Fed policy meeting. The US share market was stronger late last week and US bond yields have been relatively stable over the past week too. There is no sense that financial markets are expecting the Fed to ramp up the pace or extent of rate hikes. Although Jerome Powell comes from a different background to his predecessor Janet Yellen – mostly investment banking in the case of Powell against academic economist in the case of Yellen – their approach to setting monetary policy is viewed as likely to be similar.
Powell like his predecessor is expected to be driven by the Fed’s forecasts of growth and inflation with a view to achieving relatively stable annual inflation around 2%. The most recent set of economic forecasts released by the Fed back in December point to US growth running above potential through 2018 and 2019 using up limited excess capacity in the economy and pushing up inflation above 2% later in 2018. These forecasts warrant the current expected pattern of Fed policy tightening – three rate hikes each of 25bps in 2018 and another set of three in 2019 taking the funds rate up to 3.0% by the end of 2019.
One question is whether developments since December warrant a lift in the Fed’s growth and inflation forecasts? The Fed staff and the Fed Chairman and regional Fed Presidents go mostly on what recent economic surveys and readings show when determining the answer of whether their economic forecasts should be changed. In this sense policy change is data-dependent and that has not changed under the chairmanship of Jerome Powell, although how he interprets the data may not necessarily be the same as the way Janet Yellen might have interpreted the data.
Looking at what has happened in the US economy between the December 2017 Fed policy meeting and now the signals on balance still seem to be showing an economy that has been gathering pace producing a very tight US labour market. At one stage, the US labour market seemed to have tightened to the point of generating an inflationary push upwards in wages (2.8% y-o-y change in average hourly earnings registered in January) although the threat receded with the latest average hourly earnings report for February.
Since the December Fed policy meeting US inflation readings have also hovered close to the Fed’s 2% target, the CPI a touch above, 2.2% y-o-y in February and the core CPI, excluding food and energy prices, a touch below at 1.8% y-o-y in February. Also, alternative US inflation readings are mostly travelling nearer to 1.5% y-o-y.
What the Fed will also take some note of is that that most leading indicators of US economic remain very strong and the economic growth rate will receive an additional boost from legislated tax cuts. More likely than not, US economic growth will accelerate this year.
The US economic outlook looks strong enough for the Fed to at least maintain its December forecasts of growth and inflation. Three Fed rate hikes in 2018 are still firmly on the table. The issue is whether there has been sufficient strength in the US to warrant any upgrade to the Fed’s forecasts of growth and inflation? Our read is that minor upgrading is probably warranted building a case for four rate hikes this year.
Whether the Fed hikes three or four times this year US bond yields are likely to need to push up further from time-to-time. This move upwards in US interest rates this year will have repercussions not just inside the US economy, but outside too. Australian banks are likely to find that offshore funding becomes noticeably more expensive as the year progresses and that their lending interest rates come under pressure to rise even if the Reserve Bank continues to leave its cash rate unchanged.
Australian lenders and borrowers may have cause to start watching US Fed policy announcements as closely as they watch monthly RBA policy announcements.