Last week FOMC meeting delivered a surprisingly hawkish statement relative to very dovish expectations and triggered a sizeable repricing of the probability markets attach to a possible December rate lift off. While we have repeatedly stressed that the decision in December is likely to be a close call, and as a consequence regarded market very low probability attached to the event as too dovish, the last FOMC statement does not materially alter our assessment. Fed decisions remain data dependent, as we think is correct against the still fluid economic environment, and solid showing in activity and inflation data are still needed to tilt the balance in favour of a December rate hike. The FOMC statement had some significant changes from that in September.
The Fed said that “in determining whether it will be appropriate to raise the target range at its next meeting” it will take into account the usual broad set of measures, from the job market to international developments, but the explicit mention of “next meeting” is as plain as it gets to signal that a December rate hike is truly a possibility. What has changed in the FOMC assessment refers to the pace of growth in consumption and business investment which is now defined as “solid” as opposed to “moderate” in September, while the “pace of job gains slowed and the unemployment rate held steady”.
But, most of all, there is the removal of any hint at the recent bout of volatility that in September shaped the decision to leave rates unchanged. The sentence “recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term” which was added last month is no longer present. This signals that, in the FOMC assessment, the balance of risks weighing on the base case scenario, which would be consistent with a rate hike in December, is now more evenly distributed as the Committee is less concerned about possible negative spillovers from abroad.
This assessment probably rests also on the recent developments in the political arena. Last week was quite eventful with the approval by Congress of the bipartisan agreement on a debt limit and budget deal and the election of former Republican vice presidential candidate Ryan as House Speaker.
The approval of the budget deal suspends the debt limit until March 2017 and funds the government for the next two fiscal years, i.e. until September 2017, basically removing the tail risk of a government shutdown sometime in Q4, a situation President Obama labelled as “manufactured crises”. The budget should, according to Evercore ISI estimates, give a 0.2pp push to GDP growth next year, something the Fed may appreciate as a buffer against the headwinds that may come from weaker activity abroad and/or a strong US dollar.
The election of Ryan as House Speaker is important as he is seen as pragmatic and aware of the damages that political and fiscal brinkmanship in Congress can inflict on the US economy. Thus he will pursue the maximum achievable legislative results on a platform that has many points of contact with the bipartisan center of Congress and the Obama Adminsitration. Among them beyond the already signed, but still to detailed –by December 11 at the latest – budget, Ryan is a supporter of repatriation with international tax reform linked to the funding of multiannual spending on transportation infrastructures which he is still negotiating with the Senate Democrats and the Treasury Secretary Lew. This deal would be supportive of US GDP growth on two accounts: first through the repatriation of the almost USD2trn held by US companies abroad which would then enter the US domestic economy and by securing to long-term funding to the transportation infrastructures sector, a goal that is highly palatable to both parties ahead of an election year.
All in all, the overall degree of uncertainty on the US economic policy and growth prospects has receded over the last few days, which should be supportive of risk appetite on markets. On the specific issue of Fed policy choices, they remain data dependent but the FOMC signalled it may be less afraid of disappointing markets expectations than commonly thought: the profile of the FOMC dots should probably be followed more closely by investors.