What will they do? What should they do? Chair Yellen’s assessment that the Fed has met its goals and therefore should act, i.e., move in March to raise the funds rate. We now expect three rate increases this year.

Staying with the Dot Plot Projection

We expect the Fed to tighten 25 basis points at the March 15 FOMC meeting. The combination of incoming data that show underlying resilience in the U.S. economy and commentary by Fed officials indicating that rate hikes are likely sooner rather than later have led to a quick shift in market expectations. To follow-on the FOMC’s projections in the dot plot (top graph), we expect additional hikes in June and later this year.

- advertisement -

The FOMC, by taking on a preemptive policy action in March, avoids the complication that a surprise French election result might upend a June rate hike. A March rate hike would also make it easier for the FOMC to raise rates three times, particularly given that Yellen’s term ends in February and the president would likely appoint a successor in December.

Meeting Its Goals: A Question on Inflation and a Fog

Inflation, as measured by the PCE deflator, middle graph, is moving in the right direction, although it is not quite at the FOMC’s two percent target. Meanwhile, in our view, the FOMC’s full employment target has been more or less met. One of the three FOMC policy pillars is that policy should look forward. We expect the FOMC to work on this pillar as an improving economy pushes inflation toward the Fed’s 2 percent goal.

While the short-run path of policy is visible, the longer path remains in a fog. The claim is that the neutral fed funds rate over the long-term is one percent, and with a two percent inflation target, the longer-term target is said to be three percent. This indicates that the FOMC’s path remains consistent with the dot plot that yields a three percent fed funds rate at year-end 2019. But such a low real funds rate indicates something about productivity and real economic growth that may not be consistent with the goals of the current administration.

Twos, Tens and the Balance Sheet

Market reaction to Chair Yellen’s commentary last week was muted, suggesting that a rate hike has been largely discounted. The two-year Treasury yield has risen 10 bps over the past week (bottom chart). The 10-year Treasury yield has moved similarly. We give the Fed’s messaging "credit" for most of the move in the 10-year Treasury yield, with rising equities probably accounting for a few basis points.

Beyond the short-run normalization of monetary policy, it remains to be seen whether the Fed has accomplished the overall goal of truly stabilizing the financial system. In our opinion, another test will occur when the Fed begins to shrink its balance sheet. The move may be particularly challenging for mortgage-backed securities (MBS). However, this speed bump should be quite a way down the road. We look for the Fed to continue to reinvest its MBS at least through 2017, and probably well into 2018.

Previous articleTrade Idea: EUR/GBP – Buy at 0.8550
Next articleTrade Idea Wrap-up: USD/JPY – Sell at 114.35
Wells Fargo Securities Economics Group publications are produced by Wells Fargo Securities, LLC, a U.S broker-dealer registered with the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority, and the Securities Investor Protection Corp. Wells Fargo Securities, LLC, distributes these publications directly and through subsidiaries including, but not limited to, Wells Fargo & Company, Wells Fargo Bank N.A, Wells Fargo Advisors, LLC, and Wells Fargo Securities International Limited. The information and opinions herein are for general information use only. Wells Fargo Securities, LLC does not guarantee their accuracy or completeness, nor does Wells Fargo Securities, LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. Wells Fargo Securities, LLC is a separate legal entity and distinct from affiliated banks and is a wholly owned subsidiary of Wells Fargo & Company © 2010 Wells Fargo Securities, LLC.

LEAVE A REPLY

Please enter your comment!
Please enter your name here

This site uses Akismet to reduce spam. Learn how your comment data is processed.