The FOMC decision on December 17, 2014 will be a preview of the year ahead at the Federal Reserve
The decision for the Fed comes down to priorities. What’s more important: That the US economy is strengthening or that the global economy is weakening? That a tighter jobs market could push up wages or that lower oil prices will curb inflation?
In the eyes of the market it all boils down to a simple decision. Will the Fed remove its commitment to keep rates low for a ‘considerable time’?
The most recent statement was on October 29:
The Committee anticipates, based on its current assessment, that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program this month, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.
The statement could essentially be left unchanged by simply removing “following the end of its asset purchase program this month”.
What’s priced in?
Most economists expect the Fed to remove the commitment and replace it with some language referring to patience. For the market, the removal of the commitment is simple — it means the Fed will hike rates at the June meeting.
Despite the broad agreement from economists, the market is leaning toward the statement remaining. We looked at how the Fed funds market is pricing it last week and concluded it was about a 50/50 chance. The chance the key phrase will remain has risen since then — the implied probability of 0% or 0.25% rates in June has risen to 73.7% from 68.8% since Dec 11.
FOMC implied probabilities
Don’t forget about inflation data
There may be one more twist before the decision. The November CPI report is due at 8:30 am ET (1330 GMT) on Wednesday, just a few hours before the Fed decision. Here is a full preview of the CPI data and why it could make the difference.
Update: The CPI was released and was slightly lower than expected. That increases the possibility the Fed will leave ‘considerable time’ in the statement. On the flipside, real weekly earnings were up 0.9% so there are some signs of wage inflation and that may weigh more heavily on the Fed than headline inflation.
How will the market react?
Ultimately, the Fed will have to decide between the internal and external factors. If the Fed errs on the side of caution — as it has done so many times in the past 6 years — it sets the stage for a disappointing year for the US dollar.
There will be twists and turns in the overall impression of the Fed decision as policymakers attempt to hedge on whatever way they lean but the initial market reaction will depend entirely on ‘considerable time’.
If it’s gone, the US dollar will rally right across the board. It will harden the market belief that policy divergence between the US and the rest of the world will be the theme of 2015. The risk is that the move is short-lived because a tighter Fed will cause fear in risk trades — especially stocks and emerging markets — and that could cause a flight to the yen and chatter that Yellen is making a mistake.
If it stays, the US dollar is vulnerable but likely only for a short time. The leveraged market is piled into US dollar positions and there could be a squeeze but ultimately, traders will be faced with the choice of buying the US dollar or something else. Even if the Fed decides to wait to remove the commitment, the dollar dips still look attractive.
Will Yellen finally fire the starting pistol for rate hikes?
