US Fed Proceeds With Interest Rate Hike as Expected

US Fed Maintains Its Forecast for One More Rate Hike

The US Federal Reserve (US Fed) decided to raise its federal funds rate (FFR), the benchmark interest rate, by another 25bps in the latest June Federal Open Market Committee (FOMC) meeting. The decision marks the second rate hike for the year, leaving the FFR to be in the range of between 1.00-1.25%. The “dot plot” analysis remains mostly unchanged in the June meeting, indicating the possibility of another rate hike in the second half of the year.

The US Fed assessed that “the labour market has continued to strengthen”, while the economic activity “has been rising moderately so far this year.” There has been a clear improvement in the economic assessment as compared to the previous May FOMC statement, where the US Fed opined that the economic activity “slowed.” However, the key economic indicator for the US Fed, the inflation numbers “has declined recently,” both in terms of real numbers and market-based measures of inflation expectation. The core PCE index moderated to 1.5% yoy in May from 1.8% in March while the core inflation down to 1.7%, the lowest since May 2015. Consumer expectation survey recently showed that median three-year-ahead inflation expectations fell to 2.47% last month, from 2.91% in April, a 16-month low. Nevertheless, the improvement in inflation does not change the projected gradual tightening of US monetary policy this month.

In the latest FOMC summary of Economic Projection, the US Fed raised its 2017 GDP forecast higher from 2.1% in March to 2.2% currently. More importantly, the forecast for unemployment rate is to improve further to 4.3% as compared to 4.5% previously, while expectation of longer run unemployment rate down to 4.6% from 4.7%. At the same time, both PCE inflation and core PCE inflation numbers were revised lower to 1.6% and 1.7% respectively, from the prior forecast of 1.9% for both.

While the FOMC members maintained its “existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgagebacked securities,” the Fed clearly indicated that they expect “to begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated.” In a separate addendum, the US Fed outlined that the cap for maturing Treasury securities will begin from US$6bn per month and will increase in steps of US$6bn at three-month intervals over 12 months until it reaches US$30bn per month.

While for its agency debt and mortgage-backed securities (MBS), the cap will be US$4bn per month and will increase in steps of US$4bn at threemonth intervals over 12 months until it reaches US$20bn per month. The cap will remain in place once it reached its maximum value until the Fed perceive that they are no longer holding more securities than necessary.

Despite the improvement in inflation and some moderation in non-farm payroll numbers, which averaged 121k for March-May 17 periods against 201k in December 16 – February 17, we believe that the US Fed will likely raise its FFR by another 25 bps to 1.25-1.5% possibly in December meeting. However, based on the latest assessment, the Fed balance sheet normalization program may begin as early as September FOMC meeting, compared to earlier expectations of early 2018. However, despite the cap, we believe the actual amount of reduction will still be dependent on the amount of maturing securities held by the US Fed. It is also worth to note that most of the MBS held by the US Fed will only mature in the next decade, making the cap on MBS to be gradual.

Source: Affin Hwang Research - 15 Jun 2017