Goldman: The Fed Will Hike This Week, But Here Are "The Two Most Interesting Questions"

On Wedensday the FOMC will hike rates by another 25 bps - an event which the Fed Funds market prices in with near virtual certainty, while Goldman calls the rate increase "extremely likely" - and only a "tail" event like an extremely weak CPI report on Wednesday morning, hours ahead of the Fed announcement, has any chance of preventingthis outcome. So with the next rate hike virtually inevitable, questions are focused on not only the Fed's exit strategy for balance sheet normalization and what the "dots" or funds rate path will look like, but how the Fed squares rising rates with the recent string of inflation misses.

As Goldman's Jan Hatzius writes, data since the March meeting has sharpened the dilemma that both sides of the mandate are sending increasingly different signals about the urgency of further tightening. "The unemployment rate has fallen 0.4pp since the March meeting and our current activity indicator and real GDP estimates signal that above-trend output growth will produce further labor market improvement. But the year-over-year core PCE inflation is now 0.2pp lower than at the March meeting."

While conceding that a hike is guaranteed, Goldman notes that two issues should make this meeting particularly interesting.

• First, will Fed officials alter their policy views in response to the increasingly different signals that both sides of the mandate are sending about the urgency of further tightening?
• Second, will the press conference provide some clarity on what the next tightening step following the June hike will be?

As a result of the weaker than expected inflationary prints, Goldman believes the recent data do not call for a major change in the Fed’s policy outlook. While Hatzius expects the FOMC to lower its estimate of the structural unemployment rate by a tenth next week, even with that assumption, the new data have broadly offsetting implications for the policy outlook in standard Taylor rules. Highlighting recent Fed communications, Goldman believes the Fed will follow "a balanced approach in dealing with the dilemma."

It also means that the statement will likely characterize economic activity as "picking up but recognize that inflation slowed since earlier this year." On the other side, Goldman sees a signal of heightened inflation concern as the main dovish risk and an upgrade of the balance of risks as the main hawkish risk.

Previewing the Fed's Summary of Economic Projections (SEP), expect a modest downgrade to GDP growth for this year, coupled with declines in the unemployment rate to 4.3% this year and 4.2% next year. At the same time, projections for core PCE inflation are likely to fall to 1.8% this year and probably 1.9% in 2018. Reflecting the offsetting data news, expect the “dot plot” to show relatively stable funds rate projections.

On to Yellen's press conference, which should provide some clarity on whether the next tightening step after June will be balance sheet normalization or a third funds rate hike. Goldman, as well as much of the street, expects balance sheet adjustment to start in September and the Fed hiking cycle to resume in December. With respect to the balance sheet, the Fed will initially cap the amounts of securities that can run off in any given month of $10bn for UST and $5 billion for MBS, that rise over four quarters to caps of $40 billion and $20 billion, respectively.

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Some more details. Here is Goldman on the current economic situation, and how it will be (mis)read by the Fed.

What has the Fed communicated in recent week.

What about the revised Summary of Economic Projections

Finally, how will the Fed "renornalize" its Balance Sheet.

Goldman's conclusion:

A third consecutive quarterly rate increase next week is now extremely likely, in our view. Only an extremely weak CPI report on Wednesday morning or another tail event would prevent the committee from hiking. The data news since March has sharpened the dual mandate dilemma policymakers are facing. Our own view is that the inflation and unemployment surprises have been roughly offsetting but that the range of outcomes has widened somewhat. While the inflation outlook is uncertain, the dilemma will most likely resolve itself as inflation gradually accelerates. We therefore expect policymakers to remain focused on tightening mostly with the funds rate but also soon with the balance sheet tool.

And while we agree with Goldman in theory, one thing the bank has omitted in principle is that according to the Fed's own commercial loan data, the US economy may be just 4-6 weeks away from posting its first negative C&I loan print since the financial crisis: a virtually failsafe indication of an imminent (or concurrent) recession.

Which means that, as we explained yesterday, the Fed is about to hike in not only a disinflationary phase of the economic cycle (which is largely a function of the slowdown in the Chinese commoity bubble, and the collapse in the Chinese credit impulse), but also into what may be an outright recession in the US. If so, look for the yield curve to do what it has always done in the past after the Fed hikes rates: flatten, then flatten some more, than go horizontal, and eventually invert.