If Anything Can Shake the Fed’s 2017 Rate Path, It’s These Risks

From economic fundamentals to global politics, here's what should shake up the Fed's plans
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KPMG's Hunter Sees 3 Hikes, 70% Chance Fed Moves in June

The Federal Reserve is expected to leave policy untouched this week, a moment of calm in what could shape up to be the central bank's most active year of tightening in a decade.

Policy makers expect to raise rates twice more for a grand total of three 2017 increases, more hikes than they'd made in the previous 10 years combined. They also hope to release a plan for running off their $4.5 trillion balance sheet and possibly begin that process before the end of 2017.

Despite that active outlook, economists expect the Federal Open Market Committee to leave policy unchanged at the two-day meeting while making only minor tweaks to their policy statement, possibly to acknowledge weaker first quarter growth. Their decision will be published at 2 p.m. on Wednesday. They will probably leave open the possibility for a June rate increase without cementing it.

This month will probably mark a temporary pause in a gradual hiking path, but the Fed operates in a world of uncertainties and there's plenty that could slow the central bank — or speed it up — as the year progresses. Here are developments to watch.

The fundamentals

The Fed has dual goals of full employment and steady inflation around 2 percent, and it's roughly on track in both departments. Headline inflation stood at 1.8 percent in March while the core measure, which excludes food and energy costs, was 1.6 percent. In March, Fed officials projected that those gauges would each reach 1.9 percent on average in the fourth quarter. Unemployment is 4.5 percent, which is already in line with the level that most policy makers view as consistent with a healthy job market.


Still, growth posted a weak performance in the first quarter, with gross domestic product expanding at just a 0.7 percent annual pace. It will need to bounce back to meet the Fed's expectations of 2.1 percent expansion for the full year. If that doesn't happen, it could dim the outlook for rate increases. 

If growth or inflation outstrips Fed expectations, on the other hand, it could spur officials to either lift rates faster or begin to shrink the balance sheet sooner than expected, a move that is expected to tighten financial conditions. 

"The Fed's outlook is really based on economic fundamentals, and if growth and the labor market trend does not hold up, that could cause the Fed to go slower,'' said Gennadiy Goldberg, an interest-rate strategist at TD Securities LLC in New York. "If it heats up, that could cause the Fed to roll off the balance sheet earlier." 

European elections

The Fed has been pretty sanguine about the international outlook this year, and Chair Janet Yellen said in March that "it’s fair to say that the global economy is doing better." Still, European elections have lingered as a potential risk on the otherwise clear horizon.

France will hold the second round of its presidential ballot on May 7,  a vote that will decide between centrist Emmanuel Macron and far-right leader Marine Le Pen. Le Pen has been a loud critic of the euro area, and her victory could be disruptive for the European economy, America's largest trading partner. Macron established a firm lead in the first round of voting, alleviating major market concerns about the outcome.

"There doesn't appear to be a lot of anticipation that Le Pen is going to win — still, you have to cross that bridge before you feel really comfortable,'' said Sam Bullard, senior economist at Wells Fargo Securities LLC in Charlotte, North Carolina. Assuming Macron wins, "you take one risk event off of markets' minds.''

Germany will hold its federal election in September. Angela Merkel will run for a fourth term as Chancellor. She is the favorite to win that race, and populist parties in Europe's largest economy are polling in the single digits. 

Global stability risks

Still, other international factors cloud the global outlook in 2017. North Korea has been launching missile tests. Fighting continues in Syria, now in the seventh year of its civil war, and Islamic State terror attacks pose a persistent threat. Together, those add unpredictability to global economic projections.

"Geopolitical risk is a big one that's keeping us up at night,'' TD's Goldberg said. "It's very hard to gauge that sort of risk, of course — it's kind of an ongoing source of uncertainty.''

Fiscal policy

Domestically, the economy faces two big fiscal events. Congress must agree to raise the debt limit by sometime this autumn, and that political showdown has been destabilizing for markets in recent years. If it provokes a major crisis, it could stay the Fed's hand. 

Then there's tax and spending policy. President Donald Trump promised infrastructure spending and tax reform on the campaign trail, and if either of those come through this year, it could goose the economy and spur the Fed to hike rates more quickly. If Congress fails to accomplish much, it could disappoint markets and take some shine off of growth.

It's worth noting that most Fed officials did not explicitly factor fiscal changes into their forecasts, though they saw them as an an upside risk. That means they expect the economy to perform to their expectations even absent a tax-cut boost or new government spending.

Pretty balanced

Yellen said in March that "risks seem pretty balanced," and that hasn't really changed — developments could either spur growth or slow it. As a result, the Fed is likely to hold its course. 

The May statement will be "very much like the January statement, kind of saying `things are moving along, we're on our path,''' said Michael Feroli, chief U.S. economist at JP Morgan Chase & Co. in New York.

Feroli doesn't see any comments on the balance sheet, and while he expects the Fed to acknowledge that growth has temporarily slowed, he doesn't think policy makers will fundamentally change their assessment of economic momentum. That will leave the Fed's options open: not explicitly committing to future rate increases, but not taking them off the table, either. 

"There's a lot of runway between here and the end of the year,'' Bullard said. "There's a lot that can happen between now and then.''

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