Timing of Fed’s next rate hike remains uncertain

Analyst predicts June and December amid slowdown in quantitative easing

Minutes from the Federal Open Market Committee’s most recent meeting further support expectations for a rate hike in June, as the market is pricing in very high odds for such a move. But as is often the case, the language used by the Fed got a lot of attention.

The minutes stated that “members generally judged that it would be prudent to await additional evidence indicating that the recent slowing in the pace of economic activity had been transitory before taking another step in removing accommodation.”

They also reflect a meeting that occurred on May 3, which was followed by a very strong U.S. payroll report on May 5 that saw unemployment fall to 4.4 per cent. That matched the low of the previous economic cycle.

“So it looks like the Fed got ‘additional evidence’ even quicker than they perhaps expected,” said Tom Porcelli, chief U.S. economist at RBC Capital Markets.

Porcelli continues to forecast two more rate hikes in 2017 (June and December), with the Fed skipping a move in September to announce the framework for allowing maturing securities to run off its balance sheet.

It appears the Fed is getting closer to starting to unwind some of the quantitative easing (QE) put in place during the financial crisis and its aftermath.

The minutes revealed that nearly all members favour a cap approach, whereby the Fed sets a dollar amount ceiling for what they will allow to run off each month, and raises that cap every three months.

Porcelli noted that this makes tapering officially the Fed consensus, and the language suggests there will be a separate cap for treasuries and mortgage-backed securities.

He also pointed out that the Fed’s intention to use slow moving caps leaves open the possibility of an extended tapering process.

“With the potential for a ‘tantrum’ based on the rollout of balance sheet run-off now greatly diminished, it makes it easier for the Fed to go more than two more times this year should they decide to do so,” Porcelli said.

While a June hike looks more likely, Kevin Logan, chief U.S. economist at HSBC, thinks the timing of the next rate increase after that is becoming less certain. He attributes this to the Fed’s plans to unwind some of the QE.

“If the committee decides to get an earlier start to disinvesting some securities it acquired during the various QE programs, then the next rate hike might be postponed until sometime after the unwind begins,” Logan said.

He noted that the FOMC doesn’t need to commit to a target to begin the process of moving assets off its balance sheet.

However, once the disinvestment phase-in is complete, and the final cap that defines the pace of the unwinding is established, the market will want to know how long the process will last.

“Knowing that will allow markets to fully adapt to the disinvestment process,” Logan added.

So while the Fed will lean toward gradual rate hikes as long as the labour market continues to produce above-trend job growth, the only thing that may slow their hand is a further deceleration in inflation.

“Ongoing weakness in price growth would support those on the FOMC who see the unemployment rate as either under-reporting the level of economic slack or as not having the explanatory power in predicting inflation that it once did,” said James Marple, a senior economist at TD Bank.

He highlighted another potential fly in the ointment: the Fed’s desire to also begin normalizing its balance sheet.

“The Fed’s hope is that if telegraphed clearly and far enough in advance, and if done in a gradual and predictable manner, balance sheet normalization will have minimal deleterious effect on financial conditions and can work in tandem with short-term rate increases in gradually removing monetary accommodation,” Marple said.

It looks like the Fed got ‘additional evidence’ even quicker than they perhaps expected. TOM PORC ELLI, R BC Capital Markets