Two Big Takeaways from the Federal Reserve’s 2017 Forecast


By the time the Federal Reserve (Fed) announced on Wednesday that it was raising interest rates a quarter-point, the market had already priced in the hike as a foregone conclusion.1 What the market hadn’t priced in? The Fed’s estimate of three interest rate hikes in 2017, up from its previous view of two,and that the change to its short-term GDP growth expectations, a number that could be impacted by “Trumponomics,” would only be a slight increase.3

As Fed Chair Janet Yellen discussed the bank’s 2017 forecast in a subsequent press conference, the market took on a decidedly negative tone. The chart below captures how while bond yields rose, stocks sold off. In a reaction that underscores the negatives tones, even banking stocks—a segment that may benefit from higher rates—sold off after an initial pop.

Federal Reserve Press Conference Markets Sell Off As Fed Chair Speaks

Source: Bloomberg Finance L.P., as of 12/14/2016

Here are two important insights to put the market reaction and the Fed’s forecast into context:

1. The Federal Reserve to DC: Fiscal policy efforts are too little, too late


While central banks are losing their appetite for further stimulus, elected officials are rediscovering theirs. Governments in Britain, Japan and Canada have relaxed budgets, while US president-elect Donald Trump campaigned on promises of $1 trillion in infrastructure projects.

But just as Washington is gearing up to take the baton from the Fed and implement fiscal policy to replace monetary policy, Yellen indicated the hand-off is happening far too late.5

Indeed, the chart below illustrates that today’s economic conditions are much improved from one year ago, showing the US economy is finding its footing without massive fiscal spending. Stocks are up, GDP is higher, inflation is rising and unemployment is falling vs. a year ago.

Economic Conditions 2015 vs 2016 Were Living in a Different World


Source: Bloomberg Finance L.P., as of 12/13/2016

Rather than being worried that the US economy may backtrack without fiscal stimulus, the Fed may be more worried that it will overheat with it—leading to plans for three interest rate hikes.

2. The Fed is deliberately overpromising and underdelivering


By announcing plans for three rate increases in 2017, the Fed is also following its playbook of overpromising and underdelivering to help guide market expectations.

Last December, when the Fed raised interest rates for the first time in almost a decade, it said it expected to increase rates four times in 2016.6 But as US economic growth faltered and Brexit triggered global market anxiety, the Fed put rate hikes on pause. It did not take its finger off the pause button until this final meeting of 2016.

In forecasting three rate rises for 2017, the Fed is once again giving itself wiggle room. Not only does this wiggle room allow it to pull back on interest rate hikes if the economy slows, but it also allows it to institute all three hikes if fiscal policy triggers inflationary pressures.

However, by barely raising its 2017 GDP forecast, the Fed may also be signaling that it is not yet sold on the idea that DC will deliver as much stimulus as the president-elect is promising. So if he doesn’t deliver, the Fed can play the role of market supporter and ratchet down the hike expectations and appear accommodative.

Federal Reserve US GDP Growth Forecasts Largely Unchanged


Source: Bloomberg Finance L.P., as of 12/14/2016

After all, as shown in the chart below, the Global Economic Policy Uncertainty Index is at an all-time high. The sky-high level of uncertainty that exists around the incoming Trump administration means the Fed could be discounting any chance that fiscal policy will come to fruition, especially within the next year, as well as how the markets will react to continued populist movements with elections in France, the Netherlands and Germany.

Uncertainty Index at All-Time Highs


Source: Bloomberg Finance L.P., as of 12/15/2016


Welcome to the “New Abnormal”


If 2016 has taught us anything, it is that the world is complex and unpredictable, and the Fed’s latest press conference underscores this point. We believe investors will face a New Abnormal in 2017 that will be punctuated by significant political and economic change.

To navigate the market, investors should consider how to position portfolios to take advantage of opportunities and seek to mitigate the emerging risks of uncertain bond markets, higher inflation expectations and potential headwinds from additional populist movements.

To learn more about our views, read our full piece, 2017 Investment Outlook.

1FedWatch estimated a 90%-plus probability of a rate hike, as of 12/8/2016
2“Fed Raises Rates, Boost Outlook for Borrowing Costs in 2017,” www.bloomberg.com, as of 12/14/2016
3Bloomberg Finance L.P., as of 12/14/2016
4“Donald Trump's Infrastructure Plan Faces Speed Bumps," www.wsj.com, as of 11/11/2016
5“Fed rate hike threatens to pop Trump’s bubble,” www.politico.com, as of 12/14/2016 
6“Fed Ends Zero-Rate Era; Signals 4 Quarter-Point Increases in 2016,” www.bloomberg.com, as of 12/16/2015

Definitions

Brexit
Brexit is an abbreviation of the term “British Exit”—a reference to the United Kingdom referendum vote on June 23, 2016 to withdraw from the European Union. Supporters of Brexit argued that EU membership both hurt the competitiveness of the British economy and exposed the UK to unchecked immigration from EU countries.

Earnings Per Share (EPS)
A profitability measure that is calculated by dividing a company’s net income by the number of shares outstanding.

Global Economic Policy Uncertainty (GEPU) Index
The GEPU Index is a GDP-weighted average of national EPU indices for 16 countries: Australia, Brazil, Canada, China, France, Germany, India, Ireland, Italy, Japan, Russia, South Korea, Spain, the United Kingdom, and the United States. Each national EPU index reflects the relative frequency of own-country newspaper articles that contain a trio of terms pertaining to the economy (E), policy (P) and uncertainty (U).

Gross Domestic Product (GDP)
The monetary value of all the finished goods and services produced within a country’s borders in a specific time period.

Personal Consumption Expenditures Index (PCE)
A measure of price changes in consumer goods and services. Personal consumption expenditures consist of the actual and imputed expenditures of households; the measure includes data pertaining to durables, non-durables and services.

S&P 500 Index
The S&P 500, or the Standard & Poor’s 500, is an index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. The S&P 500 index components and their weightings are determined by S&P Dow Jones Indices.

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