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Friday, May 19, 2017

Merrill: "Will it be a summer break for the Fed?"

by Calculated Risk on 5/19/2017 01:14:00 PM

A few excerpts from a Merrill Lynch research piece: Will it be a summer break for the Fed?

The US stock market witnessed its biggest sell-off of the year on Wednesday while Treasuries rallied and the market priced in a shallower path for rate hikes. The expectation for a June hike slipped to approximately 70% from near certainty earlier in the week. We are puzzled that the market remains committed to a hike in June but skeptical about future hikes in 2018. In our view, June is a close call and will be sensitive to financial conditions in the next few weeks. We are therefore holding to our forecast that the Fed will pause at the upcoming meeting, but the Fed’s narrative between now and June 3rd (blackout period begins) will be critical for the call.
Even before this week’s events, we had been arguing that June was a close call for the following reasons:

1. Inflation has slowed: While the March weakness was due to "special factors" the disappointment in April was widespread. This has prompted us to revise down our forecast for core PCE inflation this year to 1.7% from 1.9% previously (see the Hot Topic). Meanwhile, wage growth remains sticky, which could lead the Fed to revise down their estimate of NAIRU in June’s SEP.

2. Credit conditions have deteriorated: According to the Fed's own loan officer survey, demand for consumer loans declined over the prior three months while banks have continued to tighten lending standards.

3. Real activity data have surprised to the downside: Survey measures have come off the highs and hard data have been mixed to slightly weaker, sending data surprise measures lower.

4. The Fed's narrative is stale: The April FOMC statement was a placeholder given the uncertainty around the data. The Fed can easily change the narrative about the June meeting in the coming two weeks.
We think the June meeting remains a close call and would put the probability of a hike at just under even odds – 45% chance of a hike and 55% of a pause. Conditional on the Fed not hiking in June, we think the probability of a hike in September is about 70%.
emphasis added