Market Insider

How the Fed could surprise the markets at Yellen's farewell briefing

Key Points
  • The Fed begins its two-day meeting Tuesday, and it is expected to bump interest rates by a quarter point Wednesday.
  • The wild card for the markets, however, is what the Fed says and does with regard to tax legislation.
  • Many economists and strategists expect the Fed to retain its three-rate-hike forecast, but Seth Carpenter, UBS chief U.S. economist, says the Fed could add a fourth rate hike to its forecast based on an improving economy and stimulus from tax cuts.
How the Fed could surprise the markets at Yellen's farewell meeting

The Fed is expected to raise interest rates Wednesday, but it's how the Fed responds to that is the wild card for markets.

Many strategists and economists expect the Fed to leave its interest rate forecast in place, but there's a case to be made that Fed officials could acknowledge the tax bill could create stimulus, bumping their outlook for GDP and interest rates. One argument against that is that it is the second to last meeting for Fed Chair Janet Yellen, and the Fed may stick with the status quo ahead of the expected transition to Jerome Powell as Fed chair early next year.

"The surprise we have to look for is how the Fed may interpret tax changes going forward. They've had three rate hikes for 2018. Does this move them to four? There's a very low threshold to move up to four hikes. It just takes three voters. That's really what people are going to focus on," said Jim Caron, portfolio manager and fixed income strategist at Morgan Stanley Investment Management.

Will the market rally run into 2018?

Even before Yellen's departure Feb. 3, the makeup of the Fed is changing, as are the voting members for next year, and the market expects to hear a slightly more hawkish majority.

"I really can't see it but they could surprise," said Caron, adding the Fed could acknowledge just , which should not be much of a bump for the broader economy. Yellen would then have to use her final press briefing to explain a changed interest rate forecast, but Caron said he does not expect a change in forecast or any surprises from Yellen.

Seth Carpenter, chief U.S. economist at UBS, however, says he is an "outlier" and believes the Fed could up its forecast to four interest rate hikes for 2018, instead of the current three. Carpenter said it would not be a radical departure for Fed officials, since some were already willing to consider the impact of fiscal stimulus earlier this year even when there was no legislation pending before Congress.

Now that the House and Senate are working on a combined tax bill, he said Fed officials have more reason to include a small increase in GDP growth. He expects the tax bill to add a quarter percentage point to growth in each of the next several years.

"I think they could make a change to their GDP projection. They could potentially change inflation," he said. They also could change the Fed's current 2018 forecast for three hikes, presented on the "dot plot," a chart which includes each official's forecast, presented as an anonymous dot.

Michael Gapen, chief U.S. economist at Barclays, said he expects the Fed to stick with its forecast for three interest rate hikes but some officials could up their individual forecasts to four. He said concerns about sluggish inflation could keep some Fed officials with a two or three rate hike forecast but the more they lean toward fiscal stimulus, the more chance individual officials could move up to four.

Gapen said he thinks what will happen is a "little uptick in GDP" although his guess is "inflation looks the same. That should argue for just a modest adjustment in the interest rate path. I think you have to wait for tax cuts really to have passed."

Gapen did revise higher his own forecast for rate hikes from two to three for next year, based on the falling unemployment rate and the arrival of Powell. Barclays economists now expect three rate hikes — in March, June and December — taking the federal funds rate to 2 to 2.25 percent by the end of the year. The tax cuts could begin to impact economic activity in 2018, and that could lead to a faster Fed hiking cycle if economic activity picks up.

The Fed comments are unlikely to provide much new information, and Yellen is unlikely to say much at her briefing, Gapen said. "She's probably not wanting to make news because her role is getting diminished and Powell's is getting elevated. I would just look for things to be balanced."

Update: Corrects that Yellen's briefing Wednesday is expected to be her final post-meeting briefing but her final meeting is in January.

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