What To Expect From Today's Fed Rate Decision

Despite today's unexpectedly strong ADP and ISM report, which however followed a disappointing Q4 GDP print, the FOMC meeting at 2pm should be largely uneventful. The Federal Reserve, which won't have seen Friday's payroll report yet, will only release its statement without a press conference or Summary of Economic Projections. This offers market participants less information to digest and react to, and therefore consensus expects no change from the Fed.

A quick reminder on what has happened in markets since the Fed's latest, and only second in the past decade, rate hike which has seen the yield curve has flatten:

While gold has been the best performing asset class:

Although the odds of a move at this meeting are small, March is still a possibility with futures pricing in around a 15% chance of a 25bps hike.

Odds are slim as there is still a great deal of uncertainty surrounding the new President and his policies and the USD has been volatile as a result. In light of Fed rhetoric on the subject however, the Fed is not expected to give commentary to how, if at all, the potential Trump stimulus will affect the course of monetary policy.

The median FOMC participant is expected to still call for three hikes this year, a divergence from the market's less hawkish expectations (like in 2016). The three hikes priced by the Fed do not correlate with the two hikes priced with the market, as traders are more sceptical that they will be able to increase rates at that pace, given the uncertainty surrounding Trumps potentially protectionist policies.

One development the Fed have referred to several times, and with increased stress, is the potential deflationary affect from a stronger USD and weaker global demand. The inflation data has held up so far with the core PCE figure printing just 30 bps below the Feds mandate in December. Growth figures are less favourable for the Fed — with the advanced reading for first quarter printing well below analyst expectations (1.9% vs. Exp. 2.2%) but this will be played down by the Fed until later readings confirm this (earlier today the Atlanta Fed raised its Q1 GDP forecast to 3.4% from 2.3%). Employment remains strong as well and continues to be a pillar upon which the Fed rest the normalization process.

That said, some changes to the language of the FOMC statement are expected. In particular, the Fed may highlight the reduction in labor market slack, given that the unemployment rate has fallen to 4.7%. The Fed may also note that confidence measures have improved, both business and consumer surveys. Both of these changes would be perceived as a bit more hawkish. 

In the forward-looking language, the Fed may note that inflation is expected to rise to 2% over the medium term. It is possible that they strengthen this language by noting that the reduction of labor market slack and gain in energy prices should underpin inflation in the medium term. In terms of the balance of risks, it is likely the statement will read that the near-term risks to the economic outlook "appear roughly balanced", but it is possible that they remove the word "appear" to show a greater degree of confidence.

But most importantly, virtually nobody expects any change in policy at the meeting, either in terms rates or reinvestments. The Fed is, for the time being, content to stay on hold and monitor economic conditions and potential changes to fiscal policy. That said, the FOMC will spend time discussing the exit strategy in more detail, particularly about the plan for the balance sheet as well as the dominante topic of the day in recent weeks - how to unwind the Fed's $4+ trillion balance sheet . We will have to wait for the FOMC minutes to get more specifics, however.

Market reaction:

Give there is only a 14.5% chance of a rate hike at this meeting, fast money moves surrounding the decision itself are expected to be minimal, with the accompanying statement set to take focus. Given a lot of Fed rhetoric has been rather upbeat about inflation expectations, any deferral from this line may be considered dovish. The Fed will have to be quite bullish for the market to catch up to the three that the Fed expect and one would expect to see something along the lines of 'Global and USD headwinds weighing upon inflation have eased'. It's worth noting though that given the volatility of late in the USD — choppy price action could come even if everything is as expected i.e. Fed hold rates and reiterate data dependency.

Finally, here is what one indicative bank - Nomura - expects will happen today.

We expect the FOMC to keep the federal funds target unchanged at 0.50-0.75% at the conclusion of the 31 January –1 February meeting. The data on economic activity and inflation since the last meeting have been in line with expectations.

 

We anticipate few changes in the FOMC’s statement overall:

 

The paragraph on current economic conditions (the first paragraph) should be updated modestly to reflect recent developments. But we expect the general thrust of the paragraph to be unchanged. The labor market has continued to strengthen and economic activity expanded at a moderate pace.

 

For the economic outlook (the second paragraph), we also expect only minor changes. The most recent inflation data suggest that inflation continues to very gradually creep up towards the 2% target. We expect the risk statement from the December meeting, “Near-term risks to the economic outlook appear roughly balanced,” to be repeated.

 

One area where there may be a change is the description of the labor market. During her speech on 19 January at Stanford University, Chair Yellen stated that the economy is close to full employment, or in her language, “I judge labor utilization to be reasonably close to its normal longer-run level.” Other members have expressed similar sentiments. Thus, the FOMC may change its language on the outlook for the labor market to reflect this view. However, we don’t think that this is likely. If the FOMC statement stresses that the employment has essentially reached its maximum “sustainable” level, market expectations for a hike in March would likely rise, but the uncertainty about the outlook for fiscal, and other, policies remains high.

 

Given false starts in the past – in the run ups to “tapering” in 2013 and to their rate hike in December 2015 – we do not think that the FOMC wants to send a strong signal about what they are likely to do at their meeting in March.