FOMC reviewed: FOMC to possibly hike in December - Nomura

Analysts at Nomura offered a review of today's FOMC outcome where the FOMC did not change its interest rate targets, but the Committee did acknowledge some of the positive developments that have occurred in recent weeks.

"The real innovation in today's FOMC statement was the addition of the following sentence: “Near-term risks to the economic outlook have diminished.”"

Key Quotes:

"First, recent economic data have improved.

The minutes from that meeting revealed that the Committee had real concerns as to whether the sharp slowdown in employment growth in May had broader implications for the momentum of the economy. Economic data released since then—showing a strong rebound in employment growth and solid retail sales in June—should have largely allayed those concerns. The other factor that the FOMC was probably responding to was the fact that financial conditions have eased since the last FOMC meeting, in spite of the Brexit vote.

The dollar has appreciated by about 1% on a broad trade-weighted basis since the last FOMC meeting. However, other aspects of financial conditions have eased notably since mid-June. For example, equity prices are almost 5% higher, BBB corporate credit spreads are down by 19bps, and term premia for 10-year Treasuries are 14bp lower. Taken together, the changes in equity prices, credit spreads and term premia more than offset the impact of the modest appreciation of the dollar on the outlook for the US economy. While the FOMC acknowledged the positive implications of these developments, it noted only that “near-term” risks had diminished. This is an important qualification as the US economy faces a number of significant risks beyond the next few months.

First, the economy continues to be quite sluggish given how low interest rates remain. This suggests that the current “neutral” rate of interest is still quite low. The FOMC’s forecasts imply that they expect the economy to become more robust over time, presumably implying that the temporary “shocks” that have held down the “neutral” rate should wane over time. However, one of the “long-term” risks to the FOMC’s outlook is that persistent structural factors (i.e., “secular stagnation”) may be holding down the neutral rate. In this case, the FOMC will not be able to raise short-term interest rates by as much as its current forecasts anticipate. Second, while financial markets have largely recovered since the vote, Brexit remains a significant source of uncertainty in the global outlook.

The new British government has not begun to negotiate with the rest of the European Union regarding the terms of its anticipated departure. The gap between the two sides appears to be substantial. Until we know the terms of Brexit, this will be a significant source of uncertainty for the US and global economy. Finally, to a surprising degree the US election is likely to be a source of long-term uncertainty for the US economy. In recent decades, US economic policy has generally been market-friendly and it has shown a significant degree of continuity. The consensus around important parts of that policy approach has broken down. The most obvious place is on trade.

Both Clinton and Trump oppose the proposed Trans-Pacific Partnership (TPP) trade agreement. Trump’s statements on rolling back existing trade commitments are much more radical than Clinton’s, but Clinton has also signaled a break with the policies of previous administrations. On the other hand, both Clinton and Trump support more spending on infrastructure projects. The bottom line is that there is more medium-term uncertainty about the potential course of US economic policy than we have faced in some time. Today’s FOMC statement did not mention these long-term risks explicitly, but by singling out the decline in “near-term” risks it implied that the Committee’s concerns about other risks remain.

No doubt the minutes of this week’s FOMC meeting, which will be released on 18 August, will reflect a robust discussion of these issues. It is worth noting that Kansas City Fed President George dissented from today’s decision noting that she preferred to raise interest rates today. We expect many FOMC participants to suggest in the coming weeks that their next meeting in September will be a “live” meeting. We do expect economic growth to remain at about 2% in the current quarter. However, we don’t think the key long-term risks we discussed above are likely to be resolved quickly.

On Friday we will get annual revisions to the US national accounts. We will review our assessment of potential growth after those data are released, but it will take several—perhaps many—quarters to resolve the basic questions about the trajectory of the “neutral” rate. We do not expect serious negotiations between the United Kingdom and the European Union to start until late in the year, at the earliest. Finally, the next FOMC meeting ends five days before the first debate between Trump and Clinton on 26 September. After today’s FOMC statement and given all of these factors, we continue to expect that the most likely timing for the next FOMC rate hike is at the meeting in December."