Fed Watch: Inflation Will Drive the Bus in 2016

It’s official. 2016 will be the year we can all stop obsessing over when the Fed will begin to normalize monetary policy—and start obsessing over how quickly that normalization process will be.

Assessing how that will play out depends on who you ask. The Fed has its forecast for how quickly future hikes will happen, and the market has its forecast. We can see the Fed’s forecast by the median of their so-called “dot plot,” in which each Fed voting member’s forecast of the Fed Funds rate at the end of each calendar year is denoted by a “dot” in the chart below. We can also see the market’s forecast by looking at the Overnight Indexed Swap (OIS) curve, a yield curve constructed from different maturities of Fed Funds-based derivative contracts.

Source: Bloomberg

Translation: The most recent Fed forecast calls for a Fed Funds rate of 1.375%, while the market’s forecast (OIS) is 0.877%. This means that if the Fed follows its collective forecast, the 0.25% hike that occurred in December will be followed by a total of four rate increases next year—one every quarter, most likely. (This is because the current mid-point of the Fed Funds rate target range sits at 0.375% in the wake of the December hike. Add in 4 more hikes during 2016 and we finish the year at the Fed forecast of 1.375% mid-point.)

Now contrast that with what the market is expecting the Fed Funds rate to be by the end of 2016 (0.877%). The market is only forecasting 2 hikes of 0.25% each during 2016. If we look back at recent history with respect to the accuracy of Fed Funds forecasts, the market has certainly prevailed.

Ultimately, we believe that inflation holds the clues as to whether the market’s forecast becomes more like the Fed’s, or vice versa. With the labor market seemingly relatively strong and stable, the market will likely focus far more on inflation measures and statistics as their guideposts towards handicapping the pace of Fed hikes in the coming months. This would increase the importance of inflation-related economic releases—and decrease the importance of employment statistics—in 2016.

The upshot: Paying attention to variables which can impact inflation expectations is going to be the key to correctly forecasting how quickly the pace of hikes is likely to be—closer to the Fed’s own forecast of once per quarter in 2016 or the market’s current forecast of once every 6 months in 2016.