Fed likely to still signal a third hike – Danske Bank

Besides the announcement on quantitative tightening, focus is on changes to the so-called ‘dot’plot and the FOMC statement, mainly because of the Fed’s dilemma with low inflation and low unemployment at the same time, according to analysts at Danske Bank.

Key Quotes

“While the dovish and hawkish camps have drifted further apart, we expect the median ‘dot’ to still signal a third hike this year, as we do not think four Fed members will lower their forecast (which is the necessary number in order to lower the median ‘dot’). In June, there were already four members (probably Bullard, Brainard, Evans and Kashkari, in our view) indicating no further hike this year but based on recent speeches it seems like only Kaplan may have joined them, although not all Fed members have expressed their opinions lately. In our view, Dudley’s support for further tightening was key, as he is one of the core members of the FOMC (number three after Yellen and Fischer). Dudley argued that financial conditions are very easy and that above-trend growth should put upward pressure on inflation due to the tighter labour market. For the same reason, we think the median ‘dot’ will continue signalling three hikes next year. That said, it is important to stress that while all FOMC participants are submitting their projections, only nine of them have voting rights, meaning that the ‘dots’ are likely to be biased in a hawkish direction, as many of the most hawkish Fed members are non-voters. Also, note that we for the first time will get ‘dots’ for 2020.”

“With respect to the longer-run dot, it is interesting to take note of the theoretical debate within the Fed about the level of the so-called neutral rate (simply put, it is the rate which should prevail when the output gap is closed and growth is on trend), which the longer-run dot should reflect. In his most recent speech, Kaplan mentioned he believes the long-term neutral rate is closer to 2.25% than 3.0% (the current median longer-run median dot). This statement could be an indication that the longer run ‘dots’ may be revised down. This is very interesting, as it says something about how high the Fed thinks the interest rates should go eventually (unless the Fed at some point feels the need to increase the Fed funds rate above the neutral rate) and hence at what levels US yields should trade.”

“Estimates of the current level of the neutral rate are lower than the 3% and Fed Chair Yellen has also said that the 3% is based on the expectation of an increasing neutral rate due to higher productivity growth. As Yellen thinks monetary policy is currently close to neutral (meaning that the current Fed funds rate is close to the current neutral rate), hikes further out from end-2018 onwards are due to an increasing neutral rate. If the neutral rate does not increase, it means that the hiking cycle may end sooner than most analysts expect. It seems like markets buy into that story given the very soft pricing of the Fed, partly reflecting that investors do not expect a pickup in the neutral rate in coming years.”