Tuesday, March 15, 2016

All eyes on the dots

With little or no chance of an interest rate hike from the US Federal Reserve this week, all eyes will be on the projections for interest rates as indicated by the infamous dots in the Summary of Economic Projections (SEP).  The March SEP will be released with the FOMC statement following their two day meeting this week.

It was only a few weeks ago that markets were pricing in the end of the world.  There was heightened concern about global economic growth and even talk of recession in the United States as economists raced to proclaim the highest probability of recession without actually forecasting one.
As it has turned out recent data has allayed concerns about growth and, in particular, the strength of the labour market.  Furthermore, key inflation indicators including the Committee’s preferred core personal consumption expenditure deflator are moving higher prompting Governor Stanley Fischer to recently observe the “first stirrings of an increase in inflation”.

At peak despondency, interest rate markets were pricing in no chance on interest rate increase in the United States in 2016, opening up a yawning chasm between the dots in the December edition of the SEP which had suggested four further steps towards interest rate normalisation were likely in 2016.

As the data has improved, the price of oil has risen and equity markets have recovered, interest rate markets have priced in a somewhat more realistic path for interest rates with a 50% probability of a hike in June and a 75% chance of one hike this year.

We expect much of the discussion at the meeting will centre on the market volatility seen so far this year and what that is telling the Committee about the economic outlook and the likely progress towards achieving their inflation and labour market mandates.  That seems to give the doves in the Committee the upper hand and will likely lead to a more gradual pathway to interest rate normalisation in the new SEP.

It always seemed to me the big gap in interest expectations between market pricing and FOMC projections would meet somewhere in the middle, but it will be an iterative process. I expect the FOMC will take only one or at most two rate hikes out of their projections for 2016, leaving a still sizeable amount of daylight between Committee and market expectations.  Right now I think two hikes is the right answer.  But only time...and the data...will tell.