As investors know well, the market is no fan of surprises. The Federal Reserve remains keenly aware of the market’s tendency to act out when caught unaware, and is by no means eager to trigger that. In fact, beyond the expected macroeconomic backdrop, minutes released this week from the Federal Open Market Committee’s (FOMC) latest meeting contained insight into the Fed’s situational awareness of its ability to shift markets.
FOMC members judged economic activity as continuing to expand at a “moderate pace” and labor markets as continuing to strengthen, with inflation expected to rise to the 2% target “over the medium term”. With all that in mind, the market paid specific attention to this sentence: “[M]any participants expressed the view that it might be appropriate to raise the Federal Funds Rate again fairly soon.”
Nevertheless, the statement was followed by language noting that this view was dependent on their labor market and inflation forecasts panning out. While taken together this may seem to indicate the possibility of a rate hike at the next FOMC meeting in March, we believe there are two additional factors to keep in mind.
First is the surprise factor. Certainly investors understand that in practice the FOMC can always simply do as they see fit, expected or not. Yet market expectations, as indicated by Fed Funds Futures, refuse to believe it. As of this writing, markets are assigning less than a 30% probability of a decision to increase rates at the next meeting – which means that a rate hike in March would indeed come as a surprise.
For a group previously branded as quite dovish, the Fed’s shift in tone might seem jarring. Yet this shift towards hawkishness is likely justified if one agrees that sub-5% unemployment rate reflects a tight labor market and the economy is on a 2% growth trajectory. So the natural question is: why do market participants remain so skeptical? Could it be that having been led to believe in the promise of a rate hike, only to see no action materialize again and again, that markets will now only believe it when they see it?
The second factor is more straightforward: monetary policy wants to know what fiscal policy is going to be. By March, we are not yet likely to have clarity on tax and spending policies from Congress and the new Administration. The Fed is on alert for a stimulus package, but the size, scope, and complexity remain unknown. A stimulus package could considerably alter projections for economic growth, labor market participation, and especially inflation. If the FOMC believes it’s too early to know what might be coming, and remains data dependent in waiting for clarity, that could halt them from acting in March – and market participants seem to be banking on it.
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