What's The Fed's Next Move After The December Meeting?

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The Federal Reserve is expected to raise rates in December.

But beyond the next meeting, what's next for the Fed?

I look at the current market conditions and expectations to assess what could the Fed signal for 2017.

With markets guessing how a Trump administration will shape the U.S. economy, at least when it comes to monetary policy there seems to be a consensus that the Fed will raise rates in its last meeting of the year. But moving forward it's less clear what the Fed will do given the available economic data, the uncertainty about the U.S.'s fiscal policy and market expectations regarding inflation.

According to the recent NFP report, 178,000 jobs were added - in line with expectations and around this year's monthly average. But the report also showed a slower growth in wages of 2.5% compared to 2.8% in the previous month; and the participation rate slipped again to 62.7%. With an unemployment rate of 4.6% it may seem that a fiscal stimulus won't do much to the labor market considering the low unemployment rate. But keep in mind that the U6 - a broader unemployment rate - remains high at 9.3%; in comparison, this rate was around 8.4% back before the 2008 economic meltdown.

So the market could still use a fiscal stimulus by the upcoming Trump administration especially if it were to push up wages, which should have gone up by now. The problem is, as Larry Summers pointed out, it seems unlikely that tax cuts, which are likely to be the main form of stimulus, could help boost productivity growth - one of the key components that could drive wages higher.

Considering the state of the labor market - stable growth in jobs, low unemployment and little growth in wages - the Fed isn't likely to be too keen in raising rates too fast in 2017. For now, the Fed is expected, as its members pointed out back in September, to raise rates twice next year. This could change if the Fed were to expect even higher inflation, which could become likely if there is more fiscal stimulus via infrastructure build and tax cuts. And the markets have already started to raise expectations for inflation, which was further boosted by the recent OPEC agreement that led to a rise in oil price. Nonetheless, the Fed isn't likely to revise up its outlook about the cash rate for 2017 in the next meeting and will try to remain conservative in its forecast. The Fed is likely to wait until the new administration presents its budget plan (if it ever get around to do so) before it revises its outlook and signals the markets of even more higher rates than previously expected. If it does revise up its cash rate forecast for 2017, this will be the first upward revision in years - and the markets are likely to react accordingly with even higher treasury yields and stronger dollar.

Finally, the U.S. dollar has also been gaining strength in recent months and higher possible higher inflation and interest rates, the dollar could maintain its rally in the near term. But its recovery could also play a role in the Fed's decision moving forward. Even though, exports play a small role in the U.S. GDP growth rate, the Fed doesn't want to help strengthen the dollar (although it may eventually not have a choice). Besides its impact on growth, the stronger dollar will also widen the trade deficit. These issues could be compounded if Trump moves along towards revising and tearing up trade agreements.

In conclusion

The Fed's path seems less certain after we pass the upcoming December meeting. The Fed still faces a stable labor market that doesn't yield higher wage growth and rising inflation expectations. All this comes in a time when it's unclear how fiscal stimulus will play out and how effective it will be in spurring growth. In the end, I think the Fed will remain on the side of caution and keep signaling that low rates are here to stay until new substantial evidence emerge from the newly elected administration. So in the upcoming meeting the Fed could do a "dovish hike", i.e. raise rates but keep its outlook regarding the cash rate for 2017 and onward unchanged. If so, this could help curb the recent selloff in U.S. bonds and provide a short term relief in the strengthening of the U.S. dollar. For more please see: Not All Financial Assets Are Trump-ed equally

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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