OVERVIEW

• Federal fund rate unchanged. The FOMC voted to maintain the Federal Fund Rate range at 1.00%-1.25% at its sixth monetary policy meeting for 2017. This comes after the FOMC raised rates in June by 25bp.
• Median policy rate path retained but acknowledges inflation “mystery”. The FOMC continues to see a total of three rate hikes for 2017, and indeed, in 2018 with a more sanguine economic outlook factored in. However, they revised their inflation targets, noting that the stubbornly low inflation rates to be a mystery.
• Fed asset trimming to commence October. In line with their July’s statement of portfolio normalisation to begin “relatively soon”, the FOMC revealed that they will start shrinking their USD4.5t balance sheet by October.
• Unlikely to affect OPR. Barring some volatility management on the part of BNM, we expect this US FOMC meeting to have little sway on the OPR trajectory. While Malaysia’s August inflation was higher at 3.7% on supply factors, we believe that the higher inflation is likely transitory and also manageable at the prevailing neutral OPR trajectory of 3.00% for the rest of 2017.
• Ringgit broadly stable; regional tensions weighing. With Fed’s September’s minutes sounding slightly hawkish, the ringgit may expect to be tested at USDMYR4.2 mark in the short term though as the calm settles in, we expect the ringgit to approach closer to our year end USDMYR target of 4.15. However, over the medium term, the strength of the ringgit will hinge on the escalation of tensions (or the lack thereof) in North Korea stemming from US-North Korea sabre-rattling, possibly triggering a risk-off mode for the Asian region as a whole.

Fed fund rate maintained. The Federal Open Market Committee (FOMC) unanimously maintained the Fed Fund Rate at 1.00-1.25%, a move in line with Bloomberg’s median consensus estimates, as anticipated by 102 out of 107 respondents. This was likewise echoed by the implied probability of the Fed Fund Rate futures of just 0.62% of a September rate hike. The Fed last raised the Fed Fund Rate by 25 basis points (bp) in June, emboldened by reports of strong labour market strength amid a sanguine economic outlook while shrugging off weak inflation data as transitory. Since then, market expectations for a September rate hike was sluggish at best with the probability of a Fed Fund rate hike never exceeding 25.0% since (the odds of a July rate hike was practically nil).

Hurricanes to have short-term implications. The Feds overall tone was little change from its previous meeting though they briefly discussed the likely impact of recent hurricanes affecting the US (i.e. Harvey, Irma and Martha) which they expect to have some short-term impact on inflation (affecting gasoline prices). However, they were quick to note that their prior experience suggests that these disruptions are less likely to materially affect the medium term economic scenario.

Overall, the Fed statement was at pains to avoid speculations of their prevailing rate hike trajectory being deferred, be it due to hurricane or softer inflation.

Bullish on growth; bearish on inflation.

Newly released summary of economic projections showed an upward shift in the policymakers’ growth trajectory with the median GDP growth slated at 2.4% in 2017 before easing to 2.1% and 2.0% in 2018 and 2019 respectively, revised up from its June projection calling for a 2.2% GDP growth in 2017 before easing to 2.1% and 1.9% subsequently. Improved assessment in the economic outlook also resulted in unemployment rate forecasts adjusted downwards for 2018 and 2019. A more optimistic growth assessment likely stemmed from its stronger 2Q17 economic performance of 3.0% which surprised on the upside (relative to its initial estimates of 2.6%). However, their assessment on inflation was further adjusted downwards despite their insistence that “this year's shortfall in inflation primarily reflects developments that are largely unrelated to broader economic conditions”. Core PCE, the Fed’s preferred measure of inflation was revised to 1.5% and 1.9% for 2017 and 2018 respectively (from 1.7% and 2.0% respectively in its June projections). However, the Feds stuck to their guns on the median Fed Fund rate projections with the appropriate rate at 1.25-1.50% by end-2017, implying one further rate hike for the year. Perhaps more importantly, the Fed’s median projections and gradual tightening schedule implies a further three rate hike for 2018.

Portfolio normalisation in October. The Fed also announced that it will commence the normalisation of its balance sheet (which currently amount to approximately USD4.5t) in October, largely in line with their previous timetable for a “relatively soon” asset trimming. No changes were announced to the mode or pace of trimming.

OUTLOOK

Disappointing inflation a damper on expectations. The case for a September rate hike has been severely undermined since mid-June when data of May inflation underperformed analyst expectations. Indeed, the implied probability for a September rate hike fell below the 30.0% mark on 14 June, coinciding with the conclusion of the fourth FOMC meeting (where the Fed Fund rate was hiked 25bp) and the release of the Labour Department’s report of the consumer price index (CPI) falling 0.1% MoM (vs. an expected +0.1% gain). The implied probability since dipped further on the release of each subsequent CPI data up till August.

...but markets searching for rate hike signals. However, off late, we observe that markets have been seeking signals of a fourth rate hike, in part encouraged by comments by some of the FOMC’s more hawkish members reinforcing expectations of another rate hike for 2017, particularly the comments of New York Fed President, William Dudley and Cleveland Fed

President, Loretta Mester a few weeks prior. Expectations for a third rate hike have been further drummed up by higher August CPI numbers released mid-September.

More than 50% chance for a rate hike in December. With the Oct-Nov meeting traditionally associated with lower odds of policy rate changes, all eyes are now centred on the possibility of a December rate hike. The implied probability for a December rate hike have since edged above the 50% threshold to 63.8% as at 20 September; the probability has been consistently under the 50.0% mark from mid-July to mid-September.

Transitory no longer? Overall, however, we believe that the Fed’s move to hold the Fed Fund rate at 1.00-1.25% signals the general acceptance among policymakers that the assumption of transitory soft inflation may no longer be sustainable amid prolonged periods of relatively low inflation. Indeed, Chair Janet Yellen was quick to describe this year’s inflation undershoot as a “mystery”, acknowledging imperfect understanding on the prevailing US inflation drivers. As per our previous report evaluating comments from Fed officials, there has been a notable shift in mood towards dovishness, particularly on the nature of the stubbornly soft inflation numbers with some members calling this a “policy miss”. Yellen’s opening statement also notes, in probably one of the more dovish morsel of the press release, that “the federal funds rate would not have to rise much further to get to a neutral policy stance... because the neutral rate appears to be quite low by historical standards”. However, Yellen was careful to temper any expectations against a third rate hike noting that “...because we also expect the neutral level of federal funds rate to rise somewhat over time, additional gradual rate hikes are likely to be appropriate over the next few years to sustain the economic expansion.”

Soft inflation backdrop. While the CPI rose by a stronger 1.7% in July (Jun: 1.6%) – driven by higher gasoline prices – the Fed’s preferred measure of inflation, the core PCE index, saw its weakest gains since January 2016 with a July reading of 1.4% while the headline PCE inflation reading was likewise unimpressive with a reading of 1.4%. Both of these numbers compares poorly with the Fed’s prior projection of 1.7%/1.6% core PCE/PCE inflation for 2017 and 2019 target of 2.0% growth for both of the core PCE and headline PCE. If anything, the higher August 1.7% CPI is more likely the transitory effect from temporary increase in global fuel prices.

Job market strength remains. US labour market strength has consistently been reflective of an economy approaching full employment. While the job openings have cooled somewhat in August, adding just 156,000 jobs (Jul: 189,000 jobs added) and unemployment has inched up slightly to 4.4% (Jul: 4.3%), this was likely a function of seasonal distortions with the private sector adding a modest 237,000 jobs to the economy (Jul: adding 201,000). However, as with inflation, wage growth was likewise unimpressive at just 2.5% and unchanged from June and July.

Balance sheet normalisation a good start. The Fed’s announcement on the starting month for trimming its USD4.5t balance sheet has been widely anticipated with the Fed’s providing broad strokes of its balance sheet normalisation in the June FOMC meeting and via broad-based support from comments among Fed officials subsequently. Given the managed expectations and the relatively measured approach, we believe that this winding down will likely have a

limited short-term effect on the financial markets with an initial USD10.0b (comprising USD6.0b of Treasury holdings and USD4.0b of agency debt and mortgage backed securities) curtailment in reinvestment per month before being ramped up quarterly. It is noteworthy that these amounts simply represent the natural maturity of these securities (instead of reinvesting the proceeds) rather than a liquidation of the portfolio. However, in the longer-term, with total assets projected to be lowered to around USD4.0t by the end of 2018 (i.e. similar to levels seen late-2013), we will expect to see modest increase in yields, particularly for longer-term bonds moving forward. Indeed, assuming the Feds goal of avoiding a “taper tantrum” of sorts, we believe that this will justify a more cautious approach with it rate hikes as it manages market expectations.

Policymakers tilting to dovishness. Despite September’s mildly hawkish tones, at present, we believe that the balance of voices among the FOMC voting members suggests a slight tilt towards dovishness with the doves notably led by Neel Kashkari (Minneapolis Fed) who argue for a pause in light of an “inflation miss”. Joining the doves’ camp are Lael Brainard (Fed Board of Governor), Charles Evans (Chicago Fed) and possibly Robert Kaplan (Dallas Fed). Our assessment of recent Fed comments places William Dudley (New York Fed) as the notable hawkish voice. However, after accounting for the non-voting members, we see a more balanced composition with Loretta Mester (Cleveland Fed), Eric Rosengren (Boston Fed) and Esther George (Kansas Fed) arguing for further policy tightening on concerns of frothy asset valuations and potential financial market risks. We also count James Bullard (St. Louis Fed) and John Williams (Cleveland Fed) as having a more dovish assessment on the likely Fed fund rate trajectory.

Retain house view for two rate hikes. While Septembers’ FOMC statement added more fuel to the projections of a three rate hike scenario, we are sticking to our base case scenario of just two rate hikes for 2017. Fundamentally, we are not seeing any pickup in wage growth in the horizon despite labour market strength and a more optimistic economic outlook. However, with the possibility of economic growth progressing at a faster clip than even the revised estimates of 2.4% and significant pass through effect of improved economy to wage growth, we can see a case for a third rate hike in December. However, on the belief that a delayed rate hike will be more prudent in light of US domestic uncertainties and the risk of removing accommodation prior to wage growth picking up, our odds for the third rate hike scenario is only modest, at best.

No catalyst for OPR move. While we recognise that external policy moves may prompt market stabilisation measures, on the part of Bank Negara Malaysia (BNM), we believe that this will not significantly influence the OPR trajectory. Instead, the OPR will likely be influenced by prevailing domestic inflation and growth considerations. As per our accompanying Economic Viewpoint: Malaysia Consumer Price Index, despite an uptick in August inflation to 3.7% (Jul: 3.2%) from supply-side factors, we expect inflation to remain manageable at the prevailing 3.00% OPR. At the same time, we also reckon that the current OPR is likewise accommodative of Malaysia’s growth agenda.

Short-term impact of Fed meeting to USDMYR. Fed’s mildly hawkish tones suggests that the ringgit may lose some ground against the USD in the near term. In the context of the USDMYR rates, we expect the immediate impact to be somewhat muted as we doubt that September’s meeting was significant in quelling speculations of a pause in monetary policy tightening. Nevertheless, expect the ringgit to be tested above the USDMYR4.20 mark in the short term but likely to bounce back to our year end USDMYR target of 4.15 as markets settle. However, in the broader context of the ringgit against its major trading partners, we expect the ringgit to remain broadly stable, albeit losing some ground against the Euro on a more hawkish ECB overtone of late. Relative to other advanced market economies though, the strength of the ringgit will hinge on the escalation of tensions (or the lack thereof) arising from US-North Korea sabre-rattling, possibly triggering a risk-off mode for the Asian region as a whole.

Source: Kenanga Research - 21 Sept 2017