Yellen set to lift pace of rate rises in 2017

Janet Yellen, the Federal Reserve chair, is likely to set in train an acceleration in the pace of interest rate increases on Wednesday as the US central bank responds to an economy that is hitting maximum employment and inflation that is nearing target.

An increase in short-term rates by a quarter point is probable at the meeting following a parade of signals by key policymakers in recent weeks. But with jobs data on Friday beating Wall Street expectations, previously sceptical traders are now betting that the Fed will be able to deliver on December forecasts for a total of three increases this year — with some analysts projecting four rises.

The Fed’s decision this month to deliberately and rapidly shift market expectations to a March increase underscores the strength of the US data and also the influence of buoyant financial conditions shown by the blockbuster rally in the stock market.

Strikingly, it does not yet appear to have been heavily influenced by the prospects of a fiscal loosening by Congress.

The outlook for tax reform remains deeply ambiguous, and Ms Yellen did not dwell on the possibility of a fiscal stimulus in her pre-meeting speech this month, focusing the justification for higher rates on developments in the real economy.

Some economists argue the Fed is at risk of looking flat-footed given the possibility of a tax cutting package that expands the deficit — something that would further juice an economy running closer to capacity. Even the stepped-up pace of tightening in prospect leaves the Fed on a historically shallow rate-rising path, coming after it lifted rates just twice in two years. 

Mickey Levy, an economist at Berenberg, said the central bank was in a difficult situation given the absence of any formal tax reform legislation on which to base its policy expectations. But if Congress does push through pro-growth reforms “the Fed’s policies would not only be behind the curve but way behind the curve,” he argued. 

That is not a conclusion that senior Fed policymakers share, with Ms Yellen insisting the Fed has not waited too long to tighten policy. In a recent speech she signalled continued support for the median prediction of three rate increases in 2017 contained in the central bank’s December forecasting round. 

One key question is whether the Fed will act as soon as June or wait until the northern hemisphere autumn before lifting rates again. The strength of Friday’s jobs data prompted analysts at Goldman Sachs to predict the next move after March would come in June, instead of September previously. Official data showed an extra 235,000 jobs being added in February and unemployment slipping to 4.7 per cent. 

There are also signs of a stronger inflation outlook, with the headline measure tracked by the Fed hovering just beneath its 2 per cent target. Rate-setters have also become more confident that the US will be able to weather any hazards brewing overseas. 

The guidance emerging from the Fed on Wednesday is likely to remain one of gradualism — a well-worn steer that is compatible with three or four increases in a year.

If there are signs that the US economy is getting too hot and a major fiscal expansion emerges from Congress, however, the Fed could start to feel compelled to further step up the pace of its rate increases or bring forward the day when it begins to allow its balance sheet to reduce in size.

Ms Yellen is expected during a post-meeting press conference on Wednesday to face questions about the latter topic. The balance sheet was swollen to $4.5tn during its crisis-era interventions, and policymakers have started to talk publicly about allowing it to reduce in size.

Until recently the issue appeared to be a far-off concern, but the likelihood that the Fed will accelerate from its once-a-year pace of rate increases has lifted it up the market agenda. 

While some Fed officials want to manipulate the balance sheet as an active means of steering the economy, the preference among other senior policymakers is to allow the Fed’s holdings of assets to predictably run off in the background. 

This was expressed as putting the balance sheet reduction “on autopilot” by Lael Brainard, one of the Fed governors, in a speech this month. If the US were to hit an unexpected buffer the Fed could press pause on the balance sheet run-off, but barring that outcome it would allow its holdings of securities to gradually decline towards a lower, yet-to-be-defined level.