Timing of the Next Fed Rate Hike Is Now a Balancing Act

(Bloomberg View) -- Will they or won't they? Bond traders are now pricing in odds above 75 percent that Federal Reserve policy makers will raise interest rates when they meet in two weeks, but there is still plenty of data to chew on before then. Moreover, there is no shortage of Fedspeak this week, with 11 officials lined up ahead of the blackout period, including Chair Janet Yellen and Vice Chairman Stanley Fischer.

If they want to send a strong signal either way, they still have plenty of opportunity. But maybe the data does it for them instead.

March is a tough call. On one hand, comments from Fed officials make it clear that rate hikes are coming at a faster pace than in each of the past two years. At the same time, even doubling the pace means just two 25-basis-point increases this year. A tripling means just three. So a substantial boost in the pace doesn't translate into a rush to tighten before the first quarter is complete.

The timing of the next hike is a balancing act between the need for preemptive policy to stave off inflationary pressure against the desire to let labor market strength continue to eat away at any residual underemployment. As of December, the median Federal Open Market Committee participant believed that balance was met with three 25 basis-point hikes in 2017.

That number, however, is somewhat deceptive as some of the more hawkish FOMC members, such as Richmond Federal Reserve President Jeffrey Lacker, aren't voting members this year. The voters have tended to tilt dovish, which is why I describe the forecasts within the Fed's Summary of Economic Projections as pointing toward two hikes with an option on a third. That speaks to moves in June and December and possibly September.

To pull that June rate hike forward means that the voting members of the FOMC see economic data evolve in such a way as to threaten the path to reaching their dual mandate without a faster pace of tightening. In other words, they need to believe that the need for preemptive policy has strengthened since December.

Are they already seeing that? New York Federal Reserve President William Dudley suggested just that in an interview yesterday, saying that the “case for monetary policy tightening has become a lot more compelling.” Interestingly, this seems to be not so much about the incoming data, which he says is in line with the Fed's forecast, but about expectations for fiscal policy:

We've also seen things that should make us even more confident that this is going to continue in the future. After the election we've seen very large increases in household and business confidence, we've seen very buoyant financial markets -- the stock market is up, credit spreads are narrow. And we have the expectation that fiscal policy will probably move in a more stimulative direction.

That's interesting because it suggests Dudley is considering hiking rates on developments, including as of yet unclear fiscal policy, that reflect greater upside risks to the forecast rather than the data itself. So, from his perspective, the need for preemptive policy hikes has risen. Will other voting members share this perspective, seeing the need for preemptive policy prior to the realization of these upside risks in the data?

Investors are about to get a deluge of data that may show the economy gaining strength. What am I watching? Monday's durable goods report offered a signal on capital expenditures. It wasn't a strong signal. A key cyclical indicator, non-defense non-aircraft spending slipped 0.4 percent. The general upward trend since last March remains intact, but isn't yet signaling a need to dramatically pull forward rate hikes.

Wednesday could be a big day with the release of the personal income and outlays report. It contains the Fed's preferred inflation measure, the personal consumption expenditures index. Core-PCE inflation, an indication of the likely direction of headline inflation over time, was very soft in the final quarter of 2016. Similar readings would place the Fed's inflation forecast in doubt.

In addition, the Institute of Supply Management releases its manufacturing survey on Wednesday. Solid regional surveys suggest we will see the manufacturing sector pick up as the weakness of the past couple of years continues to dissipate. On Friday, we get the non-manufacturing counterpart to assess the health of the service sector. Both could point to stronger than anticipated growth.

Finally, this week's schedule contains a flood of appearances by Fed officials. Most important are Federal Reserve Board Governor Lael Brainard today and, of course, Yellen on Friday. Both are scheduled to speak on the economic outlook. If they want to send a signal about March -- or rather, if they want to boost expectations of a rate hike -- this is their chance. Fischer speaks Friday on “Fed Monetary Policy Decision-Making,” which also offers the possibility of a signal about the March meeting. Federal Reserve Board Governor Jerome Powell also speaks on Friday, but his topic, “Innovation, Technology, and the Payments System” doesn't suggest he will comment directly on monetary policy.

The bottom line: While I suspect the Fed will pass on March, there's plenty of opportunity for the data or Fed officials to confirm or deny this forecast.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.

To contact the author of this story: Tim Duy at duy@uoregon.edu.

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net.

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