Skipping a Fed Hike in December

If the Fed decides not to hike rates at the December 18-19 FOMC Meeting, they have to do so for convincing reasons in order to avoid adverse market reactions.  Otherwise, the Treasury market could view the decision as inflationary and sell off -- which could hurt stocks.  The decision perhaps has to be based on economic growth and inflation slowing to below the Fed's Central Tendencies. 

So far, Q418 Real GDP growth is slowing but not to below the pace implied by the Fed's 2018 Central Tendency.  The Atlanta Fed model currently projects 2.5% for Q418 Real GDP Growth, which is above the 2.1% consistent with the low end of the 3.0-3.2% 2018 forecast.  It will be important to see if this projection moves down as more data come in ahead of the FOMC Meeting.

Fed officials could rationalize a decision not to hike by tilting US economic risks to the downside, citing softer foreign economic growth and the drop in the stock market.  However, not all measures of financial conditions show a tightening.  For example, the Chicago Fed's Financial Conditions Index has remained at a low level (implying easy conditions) for the past several weeks.  One factor keeping it low could be the plunge in oil prices.  The latter should boost consumption of other goods and services and offset the drag from a stock-related wealth effect.  

While skipping a hike would boost stocks, there could be some undesirable fall-out in other markets -- unless the skipping is based on solid arguments.  The Treasury yield curve could steepen, as longer-term yields build in higher inflation risks.  And, the dollar could fall, putting upward pressure on commodity and import prices.  All told, the inflation outlook could worsen, raising the odds of more aggressive Fed tightening ahead.

The undesirable fall-out could be mitigated, however, if upcoming US economic data are soft.  In particular, a weak November Employment Report and benign October PCE Deflator would make the economic background more compatible for skipping a hike.  Also, a reminder by Fed officials that a hike is a "live" possibility at each FOMC Meeting in 2019 could keep market reactions in check.

The evidence is mixed with regard to the November Employment Report, due December 7.  The Claims data softened in early November, raising the possibility of a slowdown in Payrolls or an uptick in the Unemployment Rate.  Some of the softness, however, could be temporary, related to the California fires having disrupted economic activity there.  In contrast, retail jobs could surge if news reports are correct that large retailers hired many people to deliver packages or to assist in store pickups during the holidays.  If there is a surge, it risks reversing sharply in January.

Evidence regarding Average Hourly Earnings is mixed.  A surge in relatively low-paid retail jobs would hold down AHE for compositional reasons.  But, calendar considerations argue for a 0.2-0.3% m/m increase in Average Hourly Earnings, which would put the y/y at 3.1-3.2% versus 3.1% in October.

The October Core PCE Deflator, due November 29, is likely to be benign.  It should print 0.2% m/m, based on the CPI.  The latter was boosted by a rebound in Used Car Prices, which has a smaller weight in the PCE Deflator.  Also, October's flattening in apparel prices is relatively more important and the pickup in Owners' Equivalent Rent relatively less important in the Deflator than in the CPI.  The y/y should fall to 1.9% from 2.0% in September.