The Federal Reserve will raise rates this week’ one US website boldly asserted ahead of the central bank’s meeting later today – the first under its new chairman, Jerome (Jay) Powell, who was confirmed by the Senate in January as successor to Janet Yellen.
Under Yellen the central bank has gradually raised rates in a series of ‘baby steps’, with five quarter-point hikes since the end of 2015 taking them to their current range of 1.25% to 1.5%. Last September the Fed also announced that it would start to run down the stock of bonds it purchased under a $4.5 trillion-plus quantitative easing (QE) programme
The dollar has firmed this week in anticipation. The markets expect Powell to keep to his predecessor’s strategy, with a further quarter point rate increase confirmed later today to be followed by at least two more before 2018 is over and likely two more in 2019. With other central banks around the world chafing to return to a more normal monetary policy, the success of the US in bringing the era of abnormally low rates to a close is being keenly watched.
There are nagging concerns that this ‘gently does it’ approach might need to move up a gear if US inflation stirs back to life – which could involve four rate hikes rather than three in 2018, plus three more next year.
Preparing for the role
The new chairman’s first weeks in the post suggest that the Federal Reserve isn’t about to spring any surprises for the moment though. Powell has been described as a consensus builder, who might tweak policy in response to changing economic conditions but doesn’t want to be seen as the man who pulled the plug on one of the longest US economic recoveries on record.
The new chairman was seen as the continuity candidate when he was confirmed in January as President Trump’s choice. Former colleagues have confirmed Powell’s approach as one of “if it ain’t broke, don’t fix it”, which helped him land the top job – along with a reputation for conducting meticulous research.
A former lawyer and investment banker, he has no formal training in economics – although having served as one of the Fed’s governors since 2012, he has seen first-hand its move from emergency stimulus to steer the US economy from crisis to a modest tightening of policy as growth returned and unemployment steadily reduced.
However, Powell is already aware of the need to choose his words carefully. The markets took fright in February when, in his first congressional testimony, he offered an upbeat assessment of the US economy. For many, it was no more than a statement of the obvious but stock markets chose to interpret it as an indication he was more of a hawk than Yellen.
So in addition to its rate decision, the Fed’s update assessment of the economy later today will also be closely scrutinised. With economies around the world enjoying synchronised growth for the first time in a decade, coupled with some upwards pressure on US prices and fears that Trump’s hard line on slapping tariffs on steel imported to the US might escalate into a trade war, it could be enough to accelerate inflation from its present level of just below the 2% target.
Nor is everyone happy about last December’s announced cut in the US corporate tax rate from 35% to 20%. If savings from this largesse is directed into risky investments that could just sow the seeds for the next downturn.
Reading the dot plot
This week has seen Treasury yields rising in expectation that a rate hike will follow today. The two-year yield touched 2.35%, the highest since late 2008 when the global financial crisis was at its severest. While stocks traded higher and the financial sector performed well, shares in the real estate, telecom and utilities sectors slumped ahead of today’s Fed pronouncement.
Some believe this pronouncement could extend to an upgraded economic outlook, including a reduction in the unemployment rate forecast – already at only 3.9% – higher core inflation than the current 1.9% and an annual growth rate for 2018 above the previous forecast of 2.5%.
So the tone today is likely to be mildly hawkish. The Fed’s new chairman could also face questions about US fiscal policy and the impact of tax cuts on the country’s already huge deficit. “Powell is definitely going to get asked about the trade situation in the post-meeting press conference,” says Michael Arone, chief investment strategist at State Street Global Advisors. “Those things could lead to more fireworks than people are expecting.”
All this should strengthen the dollar, which many analysts believe is currently undervalued. The greenback’s performance is influenced by the Fed’s ‘dot-plot’, a diagram which visualises each individual official’s changing expectations of where they expect the Fed’s base interest rate to be in the future.
Currently the dot-plot shows Fed officials still expect three rate hikes in 2018, but some analysts believe there is a good chance it will be revised up to reflect four hikes instead.