The Marriner S. Eccles Federal Reserve building stands past passing vehicles in this photograph taken with a tilt-shift lens in Washington, D.C., U.S. (Photographer: Andrew Harrer/Bloomberg)

Fed’s Rate-Hike Path Should Remain a Close Call

BloombergOpinion

(Bloomberg Opinion) -- For bond traders, so much depends upon a single Federal Reserve voter.

With policy makers prepared to deliver a well-telegraphed interest-rate increase, the market’s focus is on the “dot plot,” which shows central bankers’ outlook for future hikes. In March, the group was evenly split between three and four moves in 2018. That means if just one voting member shifts to a quicker pace, the committee’s entire median will adjust. 

Now, for those steeped in the nuances, that change may not mean much, knowing what was behind it. And Fed Chairman Jerome Powell tried to caution the markets against looking at the dots as a whole in his March press conference, saying they represent “individual forecasts” that represent “a range of views.” The only thing that actually happened at that meeting, he said, was a rate hike.

But he and other Fed officials surely know how the market tends to react to any change in forward guidance. And that’s why, even though they make individual expectations, policy makers have to consider what their collective outlook will signal to traders for the rest of the year.

Fed’s Rate-Hike Path Should Remain a Close Call

A shift higher in the 2018 median would most likely push two- and five-year Treasury yields higher, flattening the curve even closer to zero. It’s no secret that the prospect of inversion is on the minds of Fed officials, who want to keep the economic expansion rolling rather than help bring about one of the clearest warning signs of an impending recession. That’s one big reason not to rock the boat.

Also, while the Fed may not want to admit this, it isn’t immune to global shocks, and a few have happened since March, from Italy’s political turmoil to emerging-market countries’ struggle with the burden of a stronger dollar. Central bankers have pointed out risks abroad before, but they might not be so explicit this time. Powell said last month that the impact of U.S. monetary policy on foreign financial conditions is “often exaggerated.”

What’s remarkable is that through all the bumps over the past three months, the Fed still has bond traders right where it wants them. The market is pricing in about 2.25 rate hikes for the rest of 2018 — essentially taking officials at their word that they’ll move in June and then once more this year while giving them the option of another without causing a shock.

This sort of “optionality” is something the Fed could only dream of a short time ago. Remember, officials had to jawbone traders in late February 2017 into believing in a rate hike the next month. For the longest time, the market appeared to dictate what the central bank would do. Now, it’s largely the other way around. 

That sort of credibility is hard to win and easy to lose. That’s the risk of pushing the envelope and moving the 2018 median dot. 

Fed’s Rate-Hike Path Should Remain a Close Call
 

Strategists at Bank of America Corp., NatWest Markets and TD Securities are among those who don’t expect the dot plot for this year to change. NatWest says “it is a very close call,” just as it was back in March. 

And perhaps that’s the way it should be, with so many lingering questions outstanding, as Bloomberg News’s Jeanna Smialek detailed. For instance, what is the neutral rate, and should the Fed pause there or push further into restrictive territory? In the eurodollars market, the spread between December 2020 and March 2021 contracts is below zero, indicating when traders are expecting to see the end of the central bank’s tightening cycle. 

Another question: Where is the wage growth? Even with the U.S. unemployment rate matching a 48-year low, average hourly earnings adjusted for inflation were unchanged in May from a year earlier, according to Labor Department data released Tuesday. It’s the lowest since February 2017 and one of only a handful of zero or negative readings since 2012.

Of course, it’s easy to nitpick and find reasons for the Fed to move faster or slower. Among the arguments to raise rates in a hurry is headline inflation, which was 2.8 percent in May, the highest since February 2012. The core consumer price index accelerated the most in more than a year. If that’s not meeting the central bank’s dual mandate, what is?

It’s this dynamic that makes a “close call” all the more palatable for markets, and, it would seem, for central bankers. Traders have shown they’ll raise their expectations along with stronger data and Fedspeak, even beyond what the dots suggest. That means officials should be in no rush to raise them, if they want to ensure their 18-month streak of delivering on expectations remains intact.

©2018 Bloomberg L.P.