Fed Watch 8220 balanced 8221 focus

This is a shorter version of an article which ran on Tuesday night.

US rate-setters face a similar threat to their credibility as their Bank of Japan counterparts who earlier announced significant changes to the BoJ’s quantitative easing programme, but no immediate action.

At the Fed too, concrete action is also off the table, albeit on the tightening side of monetary policy instead of the relentless easing bias of the BoJ.

Fed policymakers are widely expected to delay raising rates for the sixth time, after projecting four further interest rises following the first in nearly a decade, last December.

Furthermore, the Fed’s policy update is expected to be accompanied by the fourth cut in 15 months of the its long-run ‘neutral rate’. The bank’s forecasts have been eroded by stubbornly weak core inflation—as weak as 1.6% year-to-year in August using the bank’s preferred Personal Consumption Expenditures (PCE) price index, well below the bank’s long-standing 2% target.

The PCE result was backed by miniscule overall Consumer Price Index (CPI) growth released last Friday. The core annual CPI outcome was unchanged at just above the Fed’s target, providing the main source of debate among Federal Open Market Committee’s rate (FOMC) setters. But a raft of recent weaker-than-expected data from other parts of the economy kept Federal funds futures contained.

Implied probability of a hike at the time of writing was just 18% compared to 12% a day earlier, according to CME Group data. Probability of a rise at November’s Fed meeting was 23%, and in December 48% vs. 45%.

Bond traders are also sceptical. The yield spread between 10-year Treasury Inflation Protected Securities (TIPS) and benchmark 10-year Treasurys widened almost two basis points to 1.5% after Friday’s CPI release. But that still left this implied bond market forecast of inflation below the Fed’s target, after it fell below 2% two years ago.

Blasé expectations and a pause in growth have crushed the Fed’s earlier hopes to hike four times this year. And then there were just two hikes projected. Now, with less than three months of 2016 left, only one rate rise seems plausible.

Fed decision: what to watch

• Conspicuous lack of recent guidance seals the probability of no federal funds target rate hike from 0.25%-0.50%. From our reckoning, the Fed has not delivered the kind of shock that a rate hike would bring whilst Fed funds futures and TIPS have been so low, since 1994.
• A ‘hold’ decision pushes the focus partly on to forecasts. Unofficial signals point to mere tweaks of economic figures, but the bank’s median long-run rate forecast could fall to 2.75%, down 1 percentage point from 18 months ago and 2.5 percentage points lower than in 2012.
• Changes to the Fed’s statement could hold clues.The July statement said risks to Fed forecasts had “diminished”. This could be changed to say risks are “balanced” or “nearly balanced”. A similar sequence of changes preceded the Fed’s first rate hike in almost a decade in December 2015. As many as 7 out of 12 rate setters have signalled a desire to hike this year, underlining thin FOMC consensus, and a more hawkish statement could be a sop to them.