Among the many consensus expectations from Yellen tomorrow is that the Chairwoman - while hiking rates by 25 bps - will cushion the announcement in extensive language explaining why this is the most dovish rate hike in history, a message which will likely be conveyed by a decline in slope of the Fed's "dots", suggesting fewer hikes over the next year.
However, that is a problem and as Deutsche Bank explains there is really no such thing as a "dovish rate hike." Here is DB's Dominic Konstam:
The Fed is “right”
The Fed is “right” to be raising rates. If they had done it earlier all the problems they now have to face, they wouldn’t have had to. If they do it later, those same problems will be even worse. Of course had they done it earlier there may well have been other problems. Like for example, no growth and a much higher unemployment rate. But that’s all water under the bridge. Fact is this Fed is ready to go. And markets know it!
So first things first. What is the Fed about to do? It appears the IOER will be set at 50 bps and the Fed will signal a higher corridor for the Funds rate, presumably 25-50 bps. We expect the overnight reverse repo rate (RRP) announcement will be in a contemporaneous statement from the FOMC, in an “implementation note”. The market arbitrages the IOER to the Funds rate (banks/other banks/GSEs) and IOER to the RRP rate (banks/money market funds). Capital constraints and FDIC insurance limit the perfect arbitrage such that the IOER should be the ceiling (50 bps) and the RRP rate (25 bps) should be the floor. The expectation is that the Funds rate will settle in the middle of the range, perhaps biased slightly lower, assuming a “less strong” arbitrage between banks and the Funds market. With that in mind the Fed might be tempted to set a higher repo rate e.g. 30 bps but then it wouldn’t make sense to have the lower end of the Funds range below that i.e. the Fed would then announce a range for Funds between 30-50 bps. More likely the Fed will be prepared to drain more liquidity for a 25 bps repo rate, perhaps initially up to $600 billion over night (double current overnight). This can obviously rise a lot and they have suggested they could suspend it. The Fed could also add term-deposits.
The next issue is what the Fed does with their dots. Last week we highlighted our view that the Fed is unlikely to drop the median dots at least for 2016 and 2017. This partly reflects the difficulty of at least two or three key voters moving together compared with say 2018 where the median is defined by one. But fundamentally it reflects the logic that in their model-driven minds the unemployment data and inflation outlook has evolved in a positive way since September and there is no need to adjust the dots. The doves almost certainly will lower their dots but this will not impact the median, only the mean. Moreover given the objective of beginning to remove accommodation is, at least for the median, to scale back credit “largesse” – in Yellen’s own words, it is better to move earlier than later when the consequences for the economy may otherwise be a deeper downturn – it doesn’t make much sense to go out of their way to appease the market.
The summary:
For those who think Fed hikes are “good” for economic confidence, it would also be odd for the Fed to suggest, implicitly via a lowering of the dots that things were not quite so rosy. On balance the Fed therefore looks set for effectively “insisting” on their median dots – closer to a hawkish rather than dovish hike.
That said, even DB notes that since not even the Fed has any idea what will happen, then clearly nobody else does either:
So sit back, relax enjoy the ride. A new regime is upon us. The next phase in the great escape from the financial crisis is about to begin!
Good luck, and as a quick reminder, this is what happened when Japan tried the same "great escape" in 2000...
... and the US, back in 1936 smack in the middle of the Great Depression when like now, it thought the economy was strong enough to sustain a tightening.