Fed faces 2015 deja vu as markets discount rate-increase chances

Bloomberg

For Janet Yellen’s Fed, 2016 is beginning to look all too familiar — another saga of disappointment and downgrade.
Last year, Federal Reserve officials started off signaling two interest-rate increases but those plans didn’t work out: Weak first-quarter U.S. growth delayed action in June, international concerns took September off the table and liftoff finally happened in December.
This year began on a similar footing. Fed officials were optimistic as they entered 2016, projecting four hikes at their meeting in December. But they downgraded that expectation in March to just two moves, after China concerns soured the outlook. Now even that forecast is looking doubtful.
First-quarter growth data have again disappointed and markets see very little chance of a hike in June, even as officials insist that the meeting is “live.” Geopolitical risks loom — including a June 23 referendum on Britain’s inclusion in the European Union, renewed concern of a Greek debt default in July and the U.S. presidential election in
November.
While many economists still see September as a likely candidate for 2016’s first rate increase, market pricing points to one hike at most, probably in December. That divergence of views underlines how hard it is to forecast the pace of monetary tightening amid global uncertainty and while the U.S. expansion remains less than robust.
A downgrade to Fed optimism “could occur again this year, for different reasons than last year,” said Laura Rosner, senior U.S. economist at BNP Paribas in New York, who doesn’t expect the Fed to raise rates at all this year. “It’s difficult for them to incorporate these headwinds and shocks into their baseline scenario.”
On one hand, U.S. growth and manufacturing data have been weaker than expected. At the same time, the job market is chugging along, if more slowly, and growth in China is showing a nascent stabilization. The Fed could get more clarity on the outlook on Friday, when U.S. retail sales data for April are set for release.
The Fed has five more meetings this year but only the gatherings in June, September and December are followed by a scheduled press conference with Chair Yellen.
While officials say they can move at any meeting, “it’s revealed preference that they prefer to move on a meeting with a press conference,” said Michael Gapen, chief U.S. economist at Barclays Plc New York.
Out of those three months, June seems like a long shot. Investors see almost no chance of a move and the Fed could harm the economy if it sprung a surprise that triggered financial market volatility.
As Goldman Sachs economist Daan Struyven pointed out in a research note this week, 90 percent of all interest-rate increases over the past 25 years were at least 70 percent discounted by markets ahead of the move, and at least 50 percent discounted 30 days before the meeting. Based on the gauge of market expectations that Goldman uses, there’s only a 12 percent expectation of a June hike right now.

June Unlikely
“The low market-implied odds, softer data, and uncertainty about the monetary transmission mechanism lead us to believe that a June hike is now rather unlikely,” Struyven wrote.
Nonetheless, Fed officials including St. Louis Fed President James Bullard and San Francisco Fed President John Williams have said that June remains an option, and Bullard told reporters in Palo Alto on May 5 that “the committee is going to do what it thinks is right, regardless of what markets think.”
Such signaling could serve to make markets realize that a hike is more than a tail risk so that “when the stars line up” and the increase is appropriate, things go smoothly, said Gennadiy Goldberg, U.S. strategist at TD Securities LLC in New York.
“September offers them a more conducive point to hike rates, but there are some arguments that they aren’t going to want to move right before the election,” said Goldberg, who expects an increase that month nonetheless.
Part of the problem stems from uncertainty over how much weight to place on the domestic economy versus events abroad.
The U.S. jobless rate has fallen to 5 percent, which is near the Fed’s estimate of full employment, though inflation remains well under its 2 percent target. On the other hand, the Fed highlighted global economic and financial risks in its March policy statement and said in April it would “closely monitor” these developments, as well as inflation.
“The markets are quite confused about what they should actually be looking at, and the Fed keeps moving the goal posts here,” Goldberg said.

2017 Outlook
Even if the Fed does manage to hike in September, 2016 might resemble 2015 in a different way — as a second year of just one increase. While economists at Bank of America and Nomura projected increases this fall, they expect that the Fed will then let policy rest until 2017.
“It’s hard for me to imagine that they would end up making more than one hike this year,” said Dartmouth College economist Andrew Levin, a former Fed economist. “June seems virtually inconceivable now, and if they do decide to hike in September, they’d probably want to wait awhile afterwards to see how things were going before hiking again.”
Undershooting its rate projections for a second year running could also call into question the four 25 basis-point increases that Fed officials have penciled in for next year.
“If you remain in a relatively unstable global economic backdrop, then it’s also reasonable to think that they’re going to have to scale back that outlook,” said Tom Porcelli, chief U.S. economist at RBC Capital Markets LLC in New York.