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Expect the Fed to Get More Aggressive on Rates

Amid signs of stronger growth and inflation, the Fed is now expected to raise rates in March, followed by a faster pace of increases well into 2018.

After two years of slow-motion monetary tightening, the policymakers at the Federal Reserve appear ready to shift into higher gear. Amid signs of stronger economic growth and a pick-up in inflation, as well as easier financial conditions, the Federal Open Market Committee, the policy arm of the U.S. central bank, is expected to raise its key federal funds rate in March by a quarter percentage point to a target range of 0.75% to 1.00%, says Ellen Zentner, Morgan Stanley’s Chief U.S. Economist.

A faster pace of Fed rate hikes could also bring forward the timing of the Fed’s plans to reduce its balance sheet.

“Recent Fedspeak suggests key monetary policymakers—even the most dovish—are supportive of a move,” Zentner says. She and her team have also revised their long-range forecast to three rate increases this year, up from two, and four more in 2018, up from three, which would bring the end-2018 range to 2.25% to 2.50%, a level not seen since before the 2008 financial crisis.

The federal funds rate, the overnight rate at which banks lend to other financial institutions, is the bedrock of the credit market. When it rises, so too do rates for everything from credit cards and car loans to mortgages and corporate and public debt.

In addition to her rates forecasts, here are some other key takeaways: 

  • Morgan Stanley’s currency strategists remain bullish about the dollar, but a recent forecast change that resulted in a 3% lower path throughout their forecast horizon would add upward pressure to Zentner’s GDP growth forecasts and boost the inflation outlook.
  • In addition, Morgan Stanley’s China economics team also recently raised its outlook for China's producer price index (PPI), with a shallower deceleration, and stronger rebound in China's PPI for finished goods—important in determining the price of goods in the U.S.
  • Zentner now expects U.S. core inflation to rise 2% over the four quarters of both 2017 and 2018, up from the prior 1.9% forecast. On a monthly basis, she now forecasts a sustained slight move through the 2% goal to a peak of 2.1% through most of the period from fourth-quarter, 2017, through third-quarter, 2018.
  • A faster pace of Fed rate hikes could also bring forward the timing of the Fed’s plans to reduce its balance sheet. Morgan Stanley has revised its expectation of the timing of that move to January in 2018, instead of April 2018, previously.

The outlook is fraught with considerable uncertainty, Zentner cautions, particularly as it relies on an uncertain delivery of fiscal policy later this year. “But that medium-term uncertainty is not enough to paralyze the FOMC and keep it from acting now, as data on the labor market, financial conditions, and inflation come together,” she says.

For more Morgan Stanley Research on the U.S. macroeconomic and Fed policy outlook, ask your Morgan Stanley representative or Financial Advisor for the full report "FOMC: Time for Change” (Mar 2, 2017). Plus, more Ideas.