Investment Research General Market Conditions 11 February 2016 Research US Fed on hold: uncertainty set to keep Fed sidelined In our view, the uncertainty in financial markets and rising risk of a systemic crisis is likely to keep the Fed from hiking before markets have settled down. We now expect the Fed to keep on hold until the September meeting, as we believe it will take some time before the current high uncertainty on the outlook will clear. Tighter financial conditions set to keep Fed on hold We anticipate the Fed will deliver three hikes in 2017. We think the Fed will use the upcoming March FOMC meeting to signal a lower trajectory for the Fed funds rate and state that it is on hold for now. No hike before the fog has cleared We believe the current financial market jitters will keep the Fed sidelined at the coming FOMC meetings. Although the US labour market is still in good shape, highlighted by the January employment report, the outlook is clouded by the recent tightening in financial conditions and the rising risk of a global systemic crisis (see also Market Turmoil, Policy Responses and Market Implications, 12 February). In the FOMC statement from the January policy meeting, the Fed chose to remove its risk bias and send a signal to the public that uncertainty on the outlook was unusually high. Since then, uncertainty has only risen. With core inflation running well below the Fed s 2% target, both survey-based and market inflation expectations trending lower and wage inflation only modestly higher, the Fed has room to be patient with the hiking cycle. We believe that the FOMC will use the coming FOMC meeting on 16 March to revise the dots lower, likely signalling two or three hikes this year, and state that it is on hold until the fog has cleared. Our base case is that the current panic in markets does not develop into a systemic financial crisis. However, risks have risen and we believe the current tightening of financial conditions will have negative spillover effects on global growth. Before moving along with the hiking cycle, we believe the Fed will need to be more confident that inflation is heading in the right direction and that GDP growth will run above potential. As a consequence and together with the subdued core inflation, inflation expectations trending down and weaker-than-expected data we have changed our Fed call and now expect only one hike this year, most likely in September (previously three hikes this year). In H2 16, when the headwind from tighter financial conditions is fading, we expect the Fed s focus to return to the fundamentals of the US economy and, in particular, the Phillips curve. We expect growth to pick up gradually, driven by solid private consumption growth and a turn in investments, which should give way to continued, although more moderate, job growth. The tighter labour market should lead to higher wage inflation supporting a continued hiking cycle with three additional in 2017 (previously four hikes next year). Source: Goldman Sachs, Bloomberg Survey based inflation expectations trending lower Source: NY Fed, Michigan, Federal Reserve Fed sees the world through the Phillips curve Senior Analyst Signe Roed-Frederiksen +45 45 12 82 29 sroe@danskebank.dk Analyst Mikael Olai Milhøj +45 45 12 76 07 milh@danskebank.dk Important disclosures and certifications are contained from page 5 of this report. www.danskeresearch.com
Yellen did not want to jump to premature conclusions Fed Chair Janet Yellen was not as soft as expected yesterday when she testified before the Financial Services Committee and, in reality, we got only a little bit of news compared with the FOMC meeting statement from January. She confirmed that, although the Fed takes financial conditions into account, it sees the world mainly through the Phillips curve. She noticed that employment is increasing and wage growth has begun to pick up. On the financial market turmoil, she said that she does not want to jump to premature conclusions and that we will get more information when FOMC members update their projections in connection with the March meeting. Our interpretation of the January FOMC statement was that the Fed will skip March, as it will not risk tightening too much, too quickly. Since the January meeting, financial stress has increased and we expect the Fed to strike a much softer tone at the March FOMC meeting. Tighter financial conditions might do the job for the Fed As Yellen mentioned in her semi-annual testimony to Congress on Wednesday, the Fed is not insulated from the rest of the world. Global central banks are generally easing monetary policy, with the Swedish Riksbank the latest to cut the repo rate, by 15bp today, which is affecting financial conditions in the US as well. Relative to the rest of the world being on hold is actually quite hawkish, as other central banks are on an easing bias. The main channel of impact is through a stronger US dollar, which is restraining growth through lower exports and is putting downward pressure on inflation. In contrast, easier monetary policy globally is also keeping longer term interest rates in the US down, thereby stimulating economic growth. However, recent Fed speak suggests the first of these effects is dominant. If global monetary policy easing leads to a significantly stronger effective US dollar, this is likely to slow the pace of the US hiking cycle below what we forecast. Strong USD restraining growth Source: Federal Reserve See the next two pages for the Fed s chart book. 2 11 February 2016 www.danskeresearch.com
FOMC chart book Employment growth slowed in January but trend growth still seems solid Unemployment rate slightly below NAIRU Wage inflation is trending up but still subdued Fed puts much weight on the Phillips curve Unit labour costs indicate higher inflation Low market inflation expectations a reason to stay on hold Source: Federal Reserve of Philadelphia, Macrobond Financial, University of Michigan, Danske Bank Source: Federal Reserve of Philadelphia, Macrobond Financial, University of Michigan, Danske Bank Fed set to take the financial turmoil into account Strong USD puts a dampener on growth Source: Macrobond Financial Source: Federal Reserve, Bloomberg, Danske Bank 3 11 February 2016 www.danskeresearch.com
Large increase in high-yield bond spreads Financial conditions have tightened significantly Source: Bloomberg Source: Goldman Sachs, Federal Reserve, Danske Bank Historically, the Fed has not increased the target range when the ISM composite is at the current level Private consumption main growth driver Note: Dark (light) shading indicates periods of tightening (easing) Source: ISM, Danske Bank Source: BEA 4 11 February 2016 www.danskeresearch.com
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