Ask any monetary policymaker last year—even the most dovish—to define the term "gradual" and it’s unlikely they would have said that it meant one interest rate hike per year. Yet, here we are, nearly a year after the Federal Reserve lifted rates a quarter percentage point above zero, where it had spent the better part of nearly a decade, and it appears that policymakers are finally ready for another step up.
The financial markets, too, are ready for another Fed move. To be sure, investors continue to concede a rising likelihood of a December rate hike, with federal funds futures trading at a level consistent with about a 75% probability. While those are the highest odds that have yet been priced for a December rate increase—even running above this same time last year—that hasn't translated into a faster expected pace of hikes after this year.
A December hike is closer to becoming a foregone conclusion, and we now expect the FOMC to follow through.
Indeed, the risk now is skewed toward less than the number of hikes that the Federal Open Market Committee (FOMC), the policy arm of the Fed, currently envisions. In fact, fed funds futures are pricing just 1.5 total hikes through the end of 2017, and a little more than two total hikes through the end of 2018. That compares with the Fed's current expectation, laid out in September, for six rate hikes through the end of 2018—one this year, two in 2017, and three in 2018.
Overpromise, Underdeliver
Looking beyond December to the path of policy next year, the FOMC will face clear hurdles when trying to deliver the two hikes it has currently penciled in. Those hikes are predicated on an economic outlook that we believe will likely be unattainable. This includes the expectation that the U.S.’s late-cycle economy reaccelerates to above potential growth, while the jobless rate falls below what is considered full employment. It’s the kind of optimism that will likely set the FOMC up for serial disappointment and, ultimately, to deliver fewer rate hikes than policymakers currently expect.
Nevertheless, a December hike is closer to becoming a foregone conclusion, and we now expect the FOMC to follow through. Since September, the incoming data has largely cleared the lower bar set by the FOMC at that meeting. No doubt, policymakers will be emboldened by the confirmation that third quarter U.S. GDP growth has rebounded to above the economy's potential. Never mind that the quarterly growth profile in our outlook pegs fourth-quarter GDP at 1.5%.
Recall that last year, the FOMC chose to increase rates in December, even though we were tracking fourth-quarter GDP growth of around 1.0%, which was later confirmed in the official data release. Instead, the Committee chose to focus on data in hand: 2015 third-quarter GDP growth that came in above potential and two knock-out employment reports showing new-job creation stretching toward an average monthly rate of 300,000.
Déjà Vu Redux
To that end, our expectation for October payrolls, to be released on Friday, November 4th, could also prime the pump for a December hike, should the data prove in line with our expectation for net job creation of 205,000 in October, which consists of a 215,000 rise on an underlying basis and a 10,000 drag from evacuations and flooding in the Southeast caused by Hurricane Matthew. We’re also assuming a further uptick in the labor force participation rate to 62.95%. However, we’re estimating that the jobs gain would still result in the unemployment rate rounding down to 4.9%, after it was rounded up to 5.0% in September. In her Q&A after the September FOMC meeting, Fed Chair Janet Yellen was keen to see the unemployment rate fall further, after it had remained largely unchanged over the past year.
What about any unexpected fallout from a December hike? Similar to last year, if the Fed approaches the December meeting with a hike in its heart, and policymakers feel that the market probabilities aren’t high enough, one well-placed comment from New York Fed President William Dudley could easily tilt the scale in the Fed's favor. Recall that last year, he surmised: "The good news is that this is probably the most well-advertised, discussed, thought about, mused-over prospect of beginning a normalization of monetary policy in history. I’m not looking for a big reaction."
While that may have been true, we believe the Fed underestimated the global market reaction to its promise that the December, 2015, hike would be followed by four additional rate increases this year. Perhaps policymakers had that in mind when contemplating changes to the path associated with their outlook at the recent September FOMC meeting. This time, a hike in December is expected to, at best, be followed by two additional hikes in 2017. That may still prove to be a too-lofty expectation, but it’s relatively much more realistic, nonetheless.
Adapted from the Morgan Stanley Research commentary “FOMC Preview: December's a Go" (Oct 28, 2016). Ask your Morgan Stanley representative or Financial Advisor for the latest coverage on U.S. economics and policy outlook. Plus, more Ideas.
