Fed's Historic Liftoff and Everything After: Decision Day Guideby
First interest rate increase since 2006 expected Wednesday
Fed watchers focused on pace hints in statement, Yellen Q&A
Here’s what to look for when the Federal Open Market Committee releases its policy statement at 2 p.m. Wednesday following a two-day meeting in Washington.
Economists and traders expect the first interest rate increase since 2006, marking the beginning of the end for the unprecedented era of easy monetary policy. The move would come at a time when a commodity slump is causing the market for high-yield bonds to gyrate, sending tremors through financial conditions indexes and spreading unease across trading desks.
While junk bonds linger as a concern, economic conditions finally point to a much-anticipated liftoff in rates: Recent data show that momentum is holding up, with consistent hiring, solid consumer spending and a modest pace of output growth. Inflation remains below the Federal Reserve’s 2 percent goal, but as officials from China to the euro area try to stoke domestic demand, international risks loom less ominously in the outlook.
There is a scheduled press conference 30 minutes after the committee’s decision is released, during which Fed Chair Janet Yellen can clarify why liftoff from zero is finally warranted -- or, in the case of a surprise hold, why it isn’t. She’ll also be able to lay out a map for future interest rate increases, the next focal point for market participants and economists.
The best clue on the hiking cycle’s slope will probably come from the so-called dot plot -- a chart sketching out officials’ projections for where rates will be in the future. Market pricing for federal funds futures implies just two interest rate increases next year, fewer than the four that the dots suggested at their most recent release, in September.
"Liftoff is essentially baked into the cake,” said Gennadiy Goldberg, U.S. strategist at TD Securities in New York. "But if the Fed capitulates on the four hikes, that would be seen as a dovish hike.”
While Fed officials will likely lower their estimates, they are probably not willing to go as far as to reinforce the market-implied projection, said Stephen Stanley, chief economist at Amherst Pierpont Securities LLC.
"I don’t think they’re eager to force a repricing now, so how do they get out of Wednesday without really upsetting the markets?" Stanley said. "They’re going to do what they can to soothe the market.”
Officials have pledged to be data-dependent during this tightening cycle, raising rates in response to incoming economic and market information. That means Fed watchers will also be attuned to any clues on what the Fed needs to see to move again, particularly when it comes to price pressures.
Yellen said during a Dec. 2 speech that the committee will "carefully monitor actual progress toward our inflation goal as we make decisions over time on the appropriate path for the federal funds rate." That statement heightened the stakes: While making a decision about initial liftoff, policy makers had been attuned to forward-looking inflation expectations rather than "actual progress."
The Fed’s preferred inflation gauge, the personal consumption expenditures index, stood at 0.2 percent in October, far below the 2 percent goal. Officials have consistently reiterated that once a slump in global commodity prices stabilizes and the dollar stops its year-and-a-half long ascent, inflation should be able to take off at last.
A separate measure of inflation, the consumer price index, firmed to 2 percent excluding food and energy in the year through November, a government report Tuesday showed.
"With policy normalization under way, it will be more important to see evidence that realized inflation is indeed moving back to target," Zach Pandl and Jan Hatzius at Goldman Sachs Group Inc. wrote in a Dec. 11 research note. Still, "the committee will likely want to retain some flexibility, and we would not expect the statement to make a direct link between incoming inflation data and the path for policy rates."
The Fed indicated in June that it plans to release an “implementation note” on the mechanics of liftoff along with their post-meeting statement. That document will give the interest on excess reserve rate and overnight reverse-repurchase rate and cap, laying out the strategy for raising rates into the Fed’s target range starting the day after the FOMC meeting.
"Some of the operational details will be under massive scrutiny," TD’s Goldberg said. "We are headed toward an unprecedented rate hike, the Fed has never hiked rates with a balance sheet this large, and people want to see that it will work.”
What probably won’t be finished at this meeting is a plan to shrink the Fed’s balance sheet, swollen to $4.5 trillion after the Fed pursued three rounds of bond buying to spur economic activity after the recession.
“They’re going to have to deal with that eventually, but not now," said John Bellows, a money manager at Pasadena, California-based Western Asset Management Co., which oversees about $450 billion in fixed-income assets. “They haven’t reached that point."
And while Yellen is likely to field questions about a rout in the bond market during her post-meeting press conference, it’s unlikely that the tumult will keep policy makers from hiking. Mutual fund Third Avenue Management rattled credit markets after telling investors in a Dec. 9 letter that its Focused Credit Fund was halting redemptions and would liquidate remaining assets. The high-yield debt market more broadly has been posting major losses.
“The Fed is always going to look at potential spillover effects into the real economy," said Tim Hopper, chief economist at asset manager TIAA-CREF in New York. “It would have to see some real spillover to the broader markets and have an impact on the overall extension of credit to the economy."
Another interesting thing to watch for on Wednesday: What degree of unanimity the committee maintains at a critical policy juncture. After the past two meetings, Richmond Fed President Jeffrey Lacker dissented because he felt that the Fed should have raised rates. If the central bank moves, there’s a chance that dissents could come from the other direction if policy makers who favor easy policy for longer choose to register their disagreement.