Global Macro Weekly Digest (Issue 64):US Fed likely to hike rates this week,marking the long awaited

The FOMC will host its monetary policy meeting on December 13-14th, where it is now widely expected by markets to boost the Fed Fund Target Rate by 25 bps to 0.5-0.75%. A December rate hike has been our call since July, when we viewed the Brexit shock and election uncertainty would push back the rate hike process. Aside from the rate hike decision itself, the FOMC will also publish updated economic forecasts and rate hike forecasts; the developments over the past several months could lead to expectations for more hawkish than originally anticipated monetary policy next year, which could lead to shifts in the current market expectations.

    The economic conditions that the Fed primarily considers are now quite favorable for a December rate hike. Firstly, the job market continues to strengthen, with the unemployment rate falling to a recovery low of 4.6% in November, and nonfarm payrolls averaging a solid 180k per month through the first 11 months of 2016. While there is a case to be made that there is still some slack left in the job market, particularly if focusing on workforce participation rate and the U6-U3 unemployment spread (a measure of how many part-time and underemployed jobs), the US job market is already at or soon approaching full employment, and has been strong enough to support a rate hike for several months already.

    Secondly, the inflation outlook has picked up noticeably over the past several months, particularly following the election of Trump. Inflationary pressures are likely to pick up in 2017, reflecting several main factors: 1) continued demand pulls inflation from the recovering economy, 2) commodity prices may bottom out, although the upside remains capped as there is a ceiling on oil prices, 3) wage push inflation is likely to continue (previous cycles have showed inflation peaking at an average of 16 months following the bottoming out of unemployment rate), 4) import inflation may pick up in the case of trade conflicts, 5) anticipated fiscal stimulus is likely to drive short-term inflation higher, and 6) healthcare inflation gets higher amid rising Obamacare premiums. Market inflation expectations have already picked up significantly over the past month, and the US economy is very likely to see a reflation scenario in 2017. In the baseline case, we see core PCE inflation trending upward toward the 2% target, and potentially topping it for several months.

    In sum, we expect the rate hike process to continue this week, and carry forward into 2017, where we expect 2-3 additional rate hikes of 25 bps each. In our view, inflation will play an increasingly important role in the Fed’s decision making progress in the upcoming year, as the job market is near or already at full employment. External risks could once again factor into the Fed’s decision making in 2017, particularly as regional risks in Europe look to be significant next year, but domestic factors should keep the Fed on track for multiple rate hikes in 2017 barring a major shock.

    The continuation of the rate hike cycle should keep the USD at strong levels in 2017, but as we communicated in our 2017 outlook, the upside for the DXY is relatively capped, as many of the pro-USD factors have already been priced in by markets. We expect the DXY to fluctuate in a range of 96-105 in 2017.