OVERVIEW

• The Federal Open Market Committee (FOMC) voted unanimously to raises the Federal Funds rate by 25 basis points (bp). This brings the Federal Funds Rate range to 0.5-0.75%.
• The Fed sees three instead of two hikes for 2017. The economic projections adjustments were mild, taking GDP growth slightly higher, but not exceeding 2.1% over the next three years.
• We reiterate our view that Bank Negara Malaysia (BNM) would maintain its Overnight Policy Rate at 3.00% for next year though, in our opinion, that there is still room for a rate cut in the event of a sharp slowdown in the economy.

No surprises in interest rate hike. The interest rate hikes were as anticipated. Federal fund futures implied a 97% probability of a 25 bp rate hike just a few days before the decision. The Fed notes continued labour market strengthening and moderate expansion in economic activty cemented the case for an interest rate hike. Due to the long build-up on interest rate expectations, we believe that this moved has already been priced in and will not result in significant market movements in its immediate aftermath. Fed’s interest rate hike will only be the second hike since the 2008 financial crisis; the last interest hike was in December 2015. While core Personal Consumption Expenditure (PCE) inflation remains below the Fed target of 2.0% (1.7% in November 2016), the hike is consistent with the Fed’s commencement of policy normalisation covered in December 2015, justifies a less accomodative monetary policy given permissive economic condition and outlook.

Fed sees three hikes for 2017. More germane for the markets are the Fed’s rate outlook for 2017. The latest dot plot implies a median midpoint of 1.1375%, up from September’s projection of 1.125%; along with Fed’s gradualism, this implies three rate hikes of 25bp in 2017. Market expect at least two hikes. The Chair, Janet Yellen, emphasises the revision is “very modest”.

The economic projections adjustments were mild, taking GDP growth slightly higher, but not exceeding 2.5% over the next three years. Growth projection has been bumped up a notch to 2.1% for 2017 from the 2.0% expectation in September – 2016 growth estimates has likewise been revised upwards to 1.9% from 1.8% (See Table 1).

OUTLOOK

Low interest rate norm? Despite Fed signals for a more gradual interest rate tightening moving into 2017, inertia from the Fed’s long flirtation with ZIRP suggests that further interest rate rises in 2017 may be biased on dovishness. Continued sub-2.0% core PCE inflation reading will reinforce the doves’ case for prolonging monetary accommodativeness, particularly if US employment metrics falters in 2017. Indeed, Fed projection maintains core PCE inflation at 1.8%, only hitting the 2.0% mark in 2018.

Trump’s wild card. The lack of clarity on actual fiscal measures passed in 2017 clouds inflation and, by extension, interest rates outlook for 2017. The Chair, Janet Yellen, notes that “it is far too early to know how these (fiscal) policies will unfold”, further noting other influencing factors. However, in her clearest remark on fiscal policy, Yellen notes that “fiscal policy is not obviously needed to provide stimulus to help us get back to full employment” though she was cautious to note that she is “not trying to provide advice… as to what is the appropriate policy stance”.

As such, we do not see an immediate case in early 2017 for interest rate hike driven by fiscal policies as Fed officials gain further clarity into the fiscal direction in 2017.

Fed independence at stake. Despite the President-elect’s prior campaign rhetoric that interest rates have remained unnaturally low, we believe that it is unlikely that Trump will eventually retain central bank independence – indeed, higher interest rates will do little to avert the eventual strengthening of the USD, possibly undermining his attempts to bring back America’s offshore manufacturing.

OPR to stay pat. On the back of the expected Fed rate hike as well as the persistently weak ringgit we believe the probability of BNM to pursue a second rate cut following a 25 bp cut in July to be rather remote at this juncture. Nonetheless, in the absence of guidance of future changes to the OPR, we view that there is still room for another rate cut if there are signs that the prevailing uncertainty in the global economy would deteriorate and drag the domestic economy down sharply. On the expectation of a slightly better domestic growth outlook next year we expect there would be no change, ceteris paribus, to the OPR in 2017.

Source: Kenanga Research - 15 Dec 2016