First Came Fed Rate Hike, Then the Fall: Decision Day Guide

Why Has the Market Turned So Negative on the Fed?
  • FOMC may find it's early to shift gears amid market turmoil
  • Falling oil prices weigh on view of inflation expectations

Federal Reserve Chair Janet Yellen and her colleagues have an unenviable task this week. They need to recognize that the economic landscape has changed without taking another interest-rate hike completely off the table at their March meeting.

While the U.S. central bank is widely expected to leave the target for the federal funds rate unchanged at 0.25 percent to 0.5 percent after a two-day gathering of the Federal Open Market Committee in Washington, here’s what else to look for when the FOMC releases its statement at 2 p.m. Wednesday:

Since the Fed announced on Dec. 16 that it was raising the benchmark interest rate for the first time since 2006, the S&P 500 stock index has fallen 9.5 percent, with oil prices down 16 percent over the same period. Morgan Stanley economists estimate that financial conditions have tightened by the equivalent of four additional hikes.

QuickTake The Fed Lifts Off

Fed officials “may try to acknowledge the market behavior and the possible negative impacts that could have on the economy, but at the same time still come across as optimistic enough on growth” to support their December projections for multiple rate increases this year, said Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities Inc. in New York.

The first paragraph in the Fed’s statement will need to update the economic description to reflect slowing U.S. growth. The economy expanded at about a 0.8 percent annualized pace in the fourth quarter, according to the median forecast of economists surveyed by Bloomberg. The Commerce Department will release an advance estimate on Friday.

Sales at U.S. retailers declined in December, raising concern about the momentum in consumer spending heading into 2016. Manufacturing in the U.S. contracted last month at the fastest pace in more than six years, hobbled by sluggish global growth and a rising U.S. dollar.

“They could say the economy appears to have moderated, something that doesn’t sound too dramatic,” said Roberto Perli, a former Fed official who’s now a partner at Cornerstone Macro LLC in Washington. The FOMC’s December statement described economic activity as "expanding at a moderate pace."

The Fed “will probably soften their current assessment a bit when it comes to household spending and business investment,” while continuing to highlight solid job gains, said Tom Porcelli, chief U.S. economist at RBC Capital Markets LLC in New York. The December statement noted that household spending and business fixed investment had been "increasing at solid rates in recent months."

Inflation Outlook

The description for the outlook of inflation also could be tweaked. Oil-price declines in January could also hamper inflation from rising back to the Fed’s 2 percent target, which it has been beneath since 2012, with prices rising 0.4 percent in the year through November.

St. Louis Fed President James Bullard, a policy-voter this year, said on Jan. 14 that “with renewed declines in crude oil prices in recent weeks, the associated decline in market-based inflation expectations measures is becoming worrisome.”

Reflecting this concern, the FOMC statement may note “market-based measures of inflation compensation moved lower,” Porcelli said. In December, policy makers said that these “remain low.”

The second paragraph could be used to underscore the notion that policy makers realize the economy has lost a step by revisiting their description of the balance of risks to the outlook, according to Michael Gapen, chief U.S. economist at Barclays Plc in New York.

Balancing Act

“They say in the December statement that the outlook for economic activity and labor markets is ‘balanced’,” he said. “Prior to December, they were saying ‘nearly balanced’ -- so what I think they can do is go back to ‘nearly balanced’.”

Doing so would preclude the need to explicitly refer to concerns about slower global growth that got them into trouble in September, Gapen said.

Against a similar backdrop of overseas gloom then, the Fed delayed a rate-rise and inserted a sentence into its policy statement warning that “recent global economic and financial developments” could slow growth and hold down inflation. It deleted the reference at its next meeting in October.

The committee may not want to repeat such language this time around because it would send investors a stronger signal about the Fed’s likely course of action in March than policy makers desire, according to Gapen.

Hawks vs Doves

Others see the opportunity for a more protracted battle between the so-called doves who want to go slowly in raising rates and the hawks who see the labor market tightening quickly and worry that will lead to inflation picking-up faster than most now expect.

Fed officials concerned about the growth outlook might push for a statement that signals no likelihood of a hike in March, said Jonathan Wright, a professor at Johns Hopkins University in Baltimore and a former Fed economist.

“I’d expect the statement to leave options open, but to lean more in the dovish direction,” he said. One option would be to refer to the downside risk from slowing global growth, or to change the projected increases in rate hikes from being “gradual” to “very gradual,” he said. “Anything like this would be a signal of a likely extended pause in tightening,” Wright said.

Premature Assessment

Robert Eisenbeis, chief monetary economist at Cumberland Advisors Inc. in Sarasota, Florida, and a former research director at the Atlanta Fed, said it would be premature for officials to overhaul the statement at this week’s meeting.

“I would expect a statement that is perfunctory,” said Eisenbeis. “They will say no move. They are waiting for signs of evidence of a pickup in inflation and are monitoring international and financial market developments.”

Fed officials in December projected four quarter-point rate increases this year. Investors see fewer than two moves, according to pricing in fed funds futures. The probability of an increase in March was just 23 percent, down from 50 percent this time last month.

Another factor to consider is the annual rotation among voter members of the FOMC, which this year may give the committee a slightly more hawkish tilt. The new voters will be Boston’s Eric Rosengren, Cleveland’s Loretta Mester, Kansas City’s Esther George and St. Louis’s Bullard. They replace John Williams from San Francisco, Chicago’s Charles Evans, Richmond’s Jeffrey Lacker and Atlanta’s Dennis Lockhart.

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