Tuesday, December 13, 2016

Buoyant Markets Pose New Challenge For The Fed

Fed officials this week are likely to signal they still expect to move gradually in lifting interest rates.

By Harriet Torry
The Wall Street Journal
December 13, 2016

A rallying stock market, rising bond yields and the return of inflationary pressures are creating new challenges for the Federal Reserve as it starts its two-day policy meeting Tuesday, with investors already looking past an expected increase in the benchmark rate and focusing on any signals about a more aggressive policy in the months and years ahead.

Leading up to the Fed’s announcement Wednesday, officials have largely maintained a cautionary tone even as joblessness sits at a nine-year low and economic growth is accelerating. But many Fed watchers see the prospect of tax cuts and fiscal spending underDonald Trump, as well as rising oil prices and inflation expectations, pointing to a pickup in the pace of rate increases.

The Fed is widely expected by investors to decide at the meeting to raise rates by a quarter percentage point to a range between 0.50% and 0.75%.

The outlook has shifted since the last time Fed officials issued economic forecasts in September. That time, they cut their outlook for growth and inflation this year, and predicted slightly higher unemployment by the end of 2016. The unemployment rate has since fallen to 4.6%—the lowest level since 2007—and economic growth accelerated in the third quarter.

Central-bank policy makers are nonetheless likely to signal Wednesday they still expect to proceed cautiously before raising rates again, despite the drastically different political backdrop and market environment since they last issued economic projections in September.

“As a central banker, I think it’s very important to be patient and let events and policies unfold, and not attempt to prejudge them…because you know they may unfold in a way that we can’t predict,” Dallas Fed President Robert Kaplan said in a recent interview with The Wall Street Journal.

The course of interest-rate increases is perhaps the pivotal factor for many investors in assessing the prospects for prices across the stock, bond, commodity and currency markets. Many money managers say an upsurge of inflation throughout 2017 ranks among the top risks to a continued advance in U.S. stocks, where the Dow industrials are on the verge of surpassing 20000 for the first time ever. Many portfolio managers and strategists are predicating predictions for rising U.S. stock indexes on the “gradual pace” of increases that Fed officials have often nodded to.

Oil prices climbed again Monday, after more oil-producing nations agreed to cut production, with U.S. crude futures gaining $1.33, or 2.6%, to $52.83 a barrel on the New York Mercantile Exchange. On the bond market, meanwhile, a gauge of 10-year inflation expectations rose to the highest level in more than two years and edged above the Fed’s 2% inflation target.

The 10-year break-even rate—the yield premium that investors demand to hold 10-year Treasury notes relative to 10-year Treasury inflation-protected securities—rose to 2.01 percentage points, its highest level since September 2014. That suggests investors, after years of skepticism, finally believe that inflation will run at around the Fed’s 2% target over the next decade.

Stocks, coming off their best week since the week of the election, were mixed on Monday, with the Dow Jones Industrial Average climbing 40 points, or 0.2%, to 19796 and the S&P 500 falling 0.1% to 2257.

Analysts at money manager BlackRock Inc. recommended buying TIPS in a report Monday, saying they expect the break-even rate to continue rising.

“The post-election jump in U.S. Treasury yields has been driven by rising growth and inflation expectations, leading investors to demand more compensation for future inflation risks,” the analysts wrote. “This supports our expectations for U.S. reflation and preference for inflation-linked bonds and value shares.”

The yield on the 10-year Treasury note settled Monday at 2.478%, up from 1.867% on Election Day and its record low of 1.366% on July 8.

Donald Trump’s election as president has boosted expectations that the next administration will cut taxes and increase spending, potentially jolting the U.S. economy out of a weak growth path since the financial crisis.

That has big implications for the Fed. The fiscal stimulus Mr. Trump has proposed could boost demand and send inflation higher.

Expectations of higher inflation have firmed further after the agreement by oil-producing nations boosted crude prices—an increase that could lead to higher consumer prices.

“Markets are indeed running on the expectation that the full package Trump has promised will come through,” said Gregory Daco, chief U.S. economist at Oxford Economics.

Economists surveyed by The Wall Street Journal last week expected four quarter-percentage-point rate increases between now and the end of 2017. Some cited rising inflation, while others said Mr. Trump’s tax and spending plans might boost price pressures or saw Mr. Trump’s potential Fed nominees advocating a more hawkish path for interest rates.

But bank officials have made clear in recent public comments they will wait to see how policies develop under Mr. Trump and a Republican-controlled Congress before the Fed rethinks policy. That means their median expectation for two quarter-percentage-point rate increases in 2017, and three each in 2018 and 2019, is unlikely to change much this week.

“It is premature to reach firm conclusions about what will likely occur,” New York President William Dudley said last week. “As we get greater clarity over the coming year, I will update my assessment of the economic outlook and, with that, my views about the appropriate stance of monetary policy.”

Federal Reserve Chairwoman Janet Yellen has said recently that the Fed has time to proceed cautiously. Despite low unemployment, pressure on wages and demand from a tight jobs market are yet to push inflation markedly higher.

Speaking to Congress in November, Ms. Yellen said the labor market has “somewhat more room” to improve than officials thought earlier this year.

A key word to look for in Wednesday’s policy statement is “gradual.” That is how the Fed has described the expected path of rate increases, and only then if the economy stays on track.

The Fed’s new projections could show little change in the path for rates and slightly more upbeat projections for unemployment, inflation and growth, given officials’ comments and recent economic data.

One thing the Fed’s “dot plot”—which charts officials’ projections for the benchmark federal-funds rate—likely won’t show are significant downgrades to estimates for that rate in the years ahead. That would mark a change from the trend over the past year: The median long-term expectation for the fed-funds rate dropped to 2.9% in September, from 3.50% a year ago.

The Fed raised its benchmark rate from near zero to a 0.25%-0.50% range last December, and began this year expecting to nudge rates up four more times in quarter-percentage-point increments.

It hasn’t moved so far because of recurrent worries about slow growth, weak inflation and turbulence overseas.

Higher borrowing costs will widen the divergence between a solid U.S. economy and the rest of the developed world, where central banks have spent this year extending rather than reducing monetary stimulus. Wednesday’s expected rate increase by the Fed will come less than a week after the European Central Bank agreed to extend its bond purchases for an additional nine months, until the end of next year, although in smaller amounts.

The Bank of England cut rates and revived a financial crisis-era bond-buying program in August in the wake of the U.K.’s decision to quit the European Union.

Divergence between the Fed and central banks in Europe and Japan “will keep U.S. rates from going up too far, too fast,” said Alan MacEachin, corporate economist at Navy Federal Credit Union.

“Divergence can’t get too wide without the dollar getting too strong,” he said, adding that will slow upward movement on U.S. rates.

A stronger dollar crimps U.S. exporters while giving a leg up to foreign ones. Lower import prices in turn act as a drag on inflation since they make foreign goods cheaper for U.S. consumers.

The dollar typically strengthens when expectations for Fed interest-rate increases rise, as dollar assets become more attractive to yield-seeking investors.

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