The bottom line is that 14 out of the 17 FOMC members, and at a minimum 7 of the 10 voting members, estimate that at least one 25bp rate hike before year-end would be appropriate.
Should the Fed hike in December – currently my core scenario – this almost unprecedented glacial pace of hikes would be in line with my January forecast of only 1-2 hikes in 2016.
The Fed’s accompanying statement and Yellen’s press conference were, if anything, reasonably upbeat. There were no direct allusions to the dollar, property, equity and bond markets or to global factors, with some justification (for now at least).
The Fed’s two main concerns are squarely centred on sub-target inflation and areas of weakness in the labour market.
It will thus be paying particular attention (and so should markets) to evidence of slack in the US labour market, with the unemployment rate becoming a less useful measure per se of labour market strength and potential wage/price pressures, in my view.
The Fed is clearly giving weight to the historically low neutral Fed funds rate. Even so FOMC members may have to further tone down their 2017-2018 estimates of the appropriate policy rate in relation to realistic (if still a little optimistic) economic forecasts.
Financial markets’ reaction has so far been mostly text-book: a jump in market pricing for a December hike to 16bp, a bull-flattening of the US yield curve, a slightly weaker dollar, a rally in EM and commodity currencies and stronger global equities.
But now comes the hard part. Volatility in Fed fund futures is likely to remain fluid in coming weeks, with financial markets increasingly sensitive to key US data, particularly on inflation and labour markets, speeches by FOMC members and presidential opinion polls.
Should Clinton win the US elections, US data improve and the Fed hike in December, I would expect the dollar to end the year stronger, EM currencies and global equities to struggle to hold onto post-US election gains and major currencies to underperform.
The more problematic scenario for the Fed (and its credibility) is one whereby Donald Trump wins and/or US economic activity slows down.
This would likely cause a sharp sell-off in global equities while safe-haven assets (e.g. gold, Swiss Franc) would outperform the dollar and in particular EM currencies. Moreover, these moves could struggle to reverse even if the Fed decided to pause in December.
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