This week, the Federal Reserve will end its eighth and final regular FOMC meeting of the year. It is widely expected that the committee will raise the target range for the federal funds rate by another 25bp to 2.25-2.50%. This would be the fourth rate hike this year, and the total increase of 100bp is the largest annual rise in the short-term interest rate since 2006. At the same time, the interest on excess reserves, IOER, will likely be raised by only 20bp. The goal of this technical adjustment is to bring the effective fed funds target rate back to the middle of the target band. The same tweak was used in June.

More important than the actual rate hike is the outlook for the coming years. The updated Summary of Economic Projections is likely to show very similar economic forecasts as in September. These include GDP growth gradually slowing from around 3% in 2018 to 2.5% in 2019 and towards potential growth of 1.8% in 2021. The jobless rate is likely seen as hovering between 3.5% and 3.75% throughout the forecast horizon, while inflation rates remain close but slightly above the 2% target. Moreover, the post-meeting statement should reiterate that “risks to the economic outlook appear roughly balanced”.

We also expect the statement to reiterate that “further gradual increases in the target range for the federal funds rate will be consistent with sustained expansions of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2% objective over the medium term.” The FOMC members’ interest rate projections (the “dots”), however, are likely to reveal that the pace of these gradual hikes is slower than the committee previously thought. In particular, we expect the dots to show only two hikes for 2019 (down from three), which brings the Fed’s median view in line with our forecast. What happens to the forecasts for 2020 and 2021 critically depends on changes to the longer-run neutral forecast of the fed funds rate. Following recent remarks by senior FOMC members, notably Fed Chair Jerome Powell at the Economic Club of New York, we think it is most likely (though not a foregone conclusion) that the median estimate for the longer-run fed funds rate will come down from 3% to 2.9% or even to 2.75%. If that is correct, the dots for 2020 and 2021 will each come down by 25bp as well, which essentially lowers the entire “dots-curve” by one rate hike. If the estimate for the longer-run rate remains unchanged, the dot for year-end 2021 will remain unchanged, but it would take the FOMC a bit longer to get there, with the hikes being more gradual, rather than occurring in 2019 and 2020.

In our view, there are two reasons for the Fed to sound more cautious on rates, while maintaining its economic outlook. First, concerns over the stock market, and second, the fact that there are greater risks to the outlook than the committee would like to admit at this point. If this is the case, the forecasts and balance of risk are only unchanged on paper.

As widely expected, the ECB announced that it will stop net asset purchases at the end of this month. Today’s highlights are Draghi’s more cautious tone on growth and additional information on the reinvestment policy, including an enhanced reinvestment guidance.

“Continued confidence with increasing caution”, this is how Draghi described the tone of the discussion within the Governing Council. While confirming the Governing Council’s confidence in the resilience of domestic demand, Draghi acknowledged that incoming data have been weaker than expected and momentum has slowed. Increased caution was more visible in the risk assessment than in the new macroeconomic forecasts, as the latter show slight downward revisions to growth and inflation numbers that do not exceed 0.1pp per year. Risks to the growth outlook are still seen as broadly balanced, but, importantly, “the balance of risks is moving to the downside”, mainly in the wake of external factors.

The enhanced reinvestment guidance states that full reinvestments will continue “for an extended period of time past the date when we start raising the key ECB interest rates”. This compares to the previous, more generic, version envisaging reinvestments to last for “an extended period of time after the end of net asset purchases”. What does this change imply in practice? In our view, it suggests that full reinvestments might continue until at least the end of 2020. As a matter of fact, we can try to "quantify" the approximate length of "extended period of time” by taking as a reference the latest change in the ECB’s rate guidance, which happened in June and replaced the expectation to keep rates unchanged for an "extended period of time" with the expectation of unchanged rates "at least through the summer of 2019". Assuming that the ECB did not make any meaningful reassessment of the outlook between April (the last time they used the old rate guidance) and the June meeting, this would imply that the ECB regards "extended period of time" as being at least one year. Therefore, if we add at least one year to the time of the first rate hike currently implied by the rate guidance, say fourth quarter of 2019, we end up with reinvestments lasting until at least the end of 2020. This time frame is broadly in line with what we had expected entering today’s meeting (similarly, market expectations were for reinvestments to last two-to-three years).

The new guidelines for reinvestments published today reveal that the ECB will gradually adjust its PSPP purchases to the new capital keys and preserve the market-neutrality of its purchases (in other words, the ECB does not plan Twist-like operations). The ECB will also aim to keep the size of each individual purchase program constant.

With net asset purchases soon behind us and more details available on the reinvestment policy, the two hot topics in the coming months will be liquidity provision to banks and the timing of the first interest rate increase. In regard to liquidity, we think the ECB will ultimately decide to extend TLTROs, probably by two years, at a less-favorable, variable interest rate (which could be the MRO rate). The rationale behind this extension would be twofold: first, it would allow the ECB to avoid a liquidity “cliff effect” as the residual maturity of outstanding TLTRO money starts to fall below one year in mid-2019, with negative consequences for banks’ net stable funding ratio. Second, it would support the transmission mechanism of monetary policy by easing funding stress for Italian banks. In regard to rate policy, if the coming months do not bring any improvement in the numbers for growth and core inflation, the ECB would feel increased pressure to make a dovish change in the rate guidance that pushes the timing of the first rate hike from after next summer into 2020.

U. S. consumer prices were unchanged in November, held back by a sharp decline in the price of gasoline, but underlying inflation pressures remained firm amid rising rents and healthcare costs.

The strength in underlying inflation reported by the Labor Department on Wednesday supports views that the Federal Reserve will raise interest rates at its December 18-19 policy meeting. The U.S. central bank has hiked rates three times this year.

November's flat reading in the CPI, which was the weakest in eight months, followed a 0.3% increase in October. In the 12 months through November, the CPI rose 2.2%, the smallest gain since February, after advancing 2.5% in October.

Excluding the volatile food and energy components, the CPI climbed 0.2%, matching October's gain. That lifted the year-on-year increase in the so-called core CPI to 2.2% from 2.1% in October.

Last month's inflation readings were in line with market expectations.

Despite the firmness in core consumer prices, the overall inflation outlook is benign amid falling oil prices and signs of slowing economic growth both in the United States and overseas.

A report on Tuesday showed producer prices edging up 0.1% in November after accelerating 0.6% in October.

The Fed's preferred inflation measure, the core PCE price index excluding food and energy, increased 1.8% year-on-year in October, the smallest gain since February, after rising 1.9% the prior month. It hit the U.S. central bank's 2% target in March for the first time since April 2012.

The market expects the core PCE price index to hover below that target for much of 2019, which they say could see the Fed temporarily halting interest rates hikes.

Minutes of the Fed's November policy meeting published last month showed nearly all officials agreed another rate hike was "likely to be warranted fairly soon," but also opened debate on when to pause further monetary policy tightening.

Traders expect no more than one rate increase in 2019. In its last forecasts in September, the Fed projected three rate hikes in 2019. is an independent macroeconomic consultancy with thousands of subscribers all over the world. We provide fundamental research to help our clients make better investing decisions. Our subscribers should expect to get access to:

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