Monetary Policymakers Wait on Trump

We now expect one more hike in 2017 and one fewer hike in 2018. We also moved up the timing of the end of the reinvestment program. 

▪ We moved our call from two hikes in 2017 to three, reflecting what we see as a strong consensus on the Committee for three hikes, conditional on an outlook similar to ours. 

▪ We now assume three hikes in 2018, rather than four, in part because we moved up the expected end of the current reinvestment program to the middle of 2018. 

FOMC participants have made clear how the FOMC would respond to fiscal stimulus. Now they are waiting on Trump and Congress for clarity on upcoming policy initiatives that will affect the path of the fund’s rate. ▪ Given that the economy is already very close to satisfying the dual mandate, the FOMC would raise  

rates more quickly to offset the divergence from the dual mandate that would otherwise follow fiscal stimulus. As we said: action, reaction. 

▪ The question is whether the FOMC will be aggressive enough to offset the effect in the first year or even by the end of 2019. If the FOMC only partially offsets it, the unemployment rate will be lower and inflation will be higher than otherwise. 

We assume that the increase in the deficit-to-GDP and debt-to-GDP ratios as a result of the coming fiscal stimulus will raise short-run r-star, with a smaller effect on longer-run r-star.  

▪ We use Laubach’s estimate that a 1 percentage point increase in the deficit-to-GDP ratio raises r-star by  25bps.  

▪ We assume a smaller effect on the longer-run level of r-star because of doubts about how persistent the changes in tax rates and spending will be. 

Yellen said participants expected short-run r-star to converge to its longer-run level by 2019. ▪ Many participants estimate that short-run r-star today is near zero. In that case, a rise in the nominal fund’s rate to 2%, which the FOMC projects by year-end 2018, would make monetary policy neutral. ▪ Participants estimate that longer-run r-star is 1%, and Yellen said that she and her colleagues expect the fund’s rate to converge toward this level (3% in nominal terms) by the end of 2019. That is what we have been assuming as well. 

While the ten-year Treasury yield has risen over 60 basis points since the election, only a portion of this appears to be attributable to a change in policy expectations. 

▪ As Jonathan Wright noted in his recent commentary, that suggests that some of the rises in the yield is a result of a widening of the term premium. 

▪ We estimate that the ten-year term premium increased by about 15 to 20 basis points after the election and we expect that to persist through the forecast period. 

Three Hikes in 2017, 2018, and 2019 

We moved from two to three hikes in 2017; it had been a close call for us between two and three, and the apparent strong consensus around three hikes tipped the scale for us. We also moved from four to three hikes in 2018, a pace that gives the FOMC room to begin phasing out reinvestments in 2018. This leaves us expecting three hikes each year in 2017, 2018, and 2019. 

Here is how we have attached names to the 2017 dots submitted for the December 2016 FOMC meeting: 

FOMC Signals Quicker Pace in Response to Fiscal Stimulus 

Before the election, market expectations derived from the OIS curve, accounting for a negative term premium, implied one or two funds rate hike per year, on average. OIS rates are up after the election, likely reflecting both a normalization of term premia and the expectation of a faster pace of hikes, perhaps one or two more rate hikes over the next few years.

Major Economic Indicators 

By default, values represent seasonally-adjusted, annualized growth rates (%) for the series indicated i n the leftmost column. 

Note on Units and Transformations 

“Quarterly” values are q/q rates; “Annual” values are q4/q4 rates. For series followed by units In parentheses, “Quarterly” values are quarterly averages, and “Annual” values are q4 averages. 

* “Quarterly” values are not compounded to annual rates.

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