MAIN POINTS is below :

1. According to the minutes of the December FOMC meeting, participants “generally” agreed that the economy was evolving “about as anticipated,” with strong growth and further strengthening of labor markets. However, participants noted the contrast between the strong economic data and concerns about downside risks from financial markets and business contacts. Participants “generally” indicated little change in their growth outlook given a downward revision on the appropriate path for monetary policy, while participants who downgraded their growth forecasts pointed to factors such as financial market developments and the global growth outlook. Contacts in a “number” of Districts appeared less upbeat than in November. Participants generally agreed that risks to the outlook appeared “roughly balanced,” but “some” noted that downside risks had increased. Downside risks included a sharper-than-expected slowdown in global growth, a more rapid waning of fiscal stimulus, an escalation in trade tensions, further tightening of financial conditions, and greater-than-expected effects from monetary policy tightening.

2. Participants again observed that core inflation “remained near 2 percent,” but they added that it had “edged lower.” And while labor markets had “remained strong” and contacts continued to report “tight” labor markets, reports and surveys suggested “some moderation in inflation pressure.” Additionally, “several” participants noted that TIPS inflation compensation had “declined notably” and “a few” thought that longer-run inflation expectations may have indeed “edged lower.” In contrast, participants’ wage growth characterization was little changed, acknowledging the uptrend to a pace “broadly in line” with the economy’s potential. Staff medium-term inflation projections were “little revised on net.”

3. Participants acknowledged that financial conditions had tightened and markets were “volatile.” “Some” participants mentioned that these developments could reflect an increased focus among market participants on tail risks, and while a “couple” of participants believed that the tightening in financial conditions did not seem to have affected the real economy so far, they were concerned about its future impact. A “couple” participants raised concerns about high debt levels in the nonfinancial corporate sector, especially among riskier firms. Some participants noted the “possible risks” to financial stability from a long period of tight resource utilization.

4. On the policy outlook, participants “generally judged” that “some further gradual increases” in the funds rate was appropriate. However, the funds rate was “at or close to the lower end” of the neutral range, and participants noted that recent volatility in financial markets had made the “extent and timing” of future hikes “less clear.” “Many” participants therefore believed that they could be “patient” on future hikes. Participants again sought to emphasize that policy was data dependent, “not on a preset course,” and that the pace and “ultimate endpoint” of future increases were both uncertain. In this vein, “several” participants believed that forward guidance should be removed and replaced with language on data dependence “over upcoming meetings.” A key change in the policy guidance language in the December postmeeting statement—from “expects that further gradual increases” to “judges that some further gradual increases”—was made to “better convey” the FOMC’s data dependency and their judgment that a “relatively limited” amount of additional hiking was appropriate.

5. The Committee also discussed several longer-run issues related to the balance sheet at the December meeting. With regard to the longer-run composition, “several” participants raised the possibility of eventually shifting the balance sheet toward shorter-maturity assets in order to provide the ability to ease by lengthening the maturity structure in a downturn, as well as the possibility of eventually implementing “very gradual” MBS sales in order to return the balance sheet to a mostly Treasury composition. Both ideas have been suggested before, and neither would happen until sometime after the balance sheet reaches its terminal size.

While participants generally viewed “some” further increase in the funds rate as appropriate, they emphasized both patience as well as data dependence for any future hikes, with some participants noting that language on forward guidance should be removed over upcoming meetings. We left our subjective odds of a March hike unchanged at 10%.

China’s Caixin manufacturing PMI fell by 0.4pp to 49.7 in December, below market expectations. Most of the sub-indexes suggest weaker growth in the manufacturing sector, although the production index rose from the previous month. The production sub-index was at 50.3 in December, vs. 50.0 in November. Despite this small increase, the production sub-index remained soft in absolute level terms and close to the bottom of its range in the recent two years. The new orders sub-index moderated to 49.8 from 50.9 in November. The new export orders sub-index rebounded to 48.3 from 47.7 in November, but it was still much lower than the average level of 50.3 in 1H 2018. Employment index edged up by 0.1pp to 48.5. Price indicators implied meaningfully lower inflation in the sector – the output price index and input price index were 1.4pp and 4.4pp lower respectively in December vs. November. Inventories indicators fell – the raw material inventories index was at 49.9 in December vs. 50.3 in November and the finished goods inventory index moderated to 50.5 in December vs. 51.0 in November.

In general, both the NBS and Caixin manufacturing PMI surveys suggest soft growth momentum in the manufacturing sector in December. Trade growth may have weakened and domestic demand growth could have stayed soft. Companies showed willingness of destocking at both input and output levels. Price inflation was lower amid falling commodity and oil prices, which could have added downward bias to the headline manufacturing PMI readings. We continue to expect more loosening measures to be announced by the government to support economic growth.

The following points are worth noting:

Although this meeting is supposed to set the tone of economic policy making for the next year as a whole, it’s actually more a reflection of the policy stance in the next few months. Actual policy making will be adjusted on a real time basis according to the latest developments. This is especially true for next year as the trade conflict with the US, one of the biggest factors affecting the economy, remains highly uncertain.

The PBOC announced today that it will initiate a Targeted Medium-Term Lending Facility (TMLF). The facility is for one year but can be extended twice, effectively making it three years. Qualified state owned banks, share holding banks, and large city commercial banks will be able to receive it. The interest rate to be charged is 15 bps lower than the standard MLF (which is currently 3.15%), but this liquidity must be used for lending to small and private enterprises.

The PBOC also said it will increase relending and rediscount quotas by 100bn RMB, for lending to small companies and private enterprises only.

These measures will not necessarily lead to lower interbank rates as they may act as substitutes for other liquidity measures. Lowering interest rates is easily justifiable in light of weak growth and lower inflation. But there seems to be significant determination to maintain currency stability because of the ongoing trade negotiations and concerns about the effects on the financial markets and economy. Lowering interbank interest rates would put additional pressure on the currency. Therefore, this is likely a small additional loosening measure to lower the cost of funding for commercial banks allowing them to lower their lending rates. The move was likely in response to recent weakness in economic activity and TSF growth, lower inflation, and the President’s stated desire to support private enterprises.

In the coming months, we anticipate further loosening measures which we expect will continue to be incremental and conditional on the changes in the economy. The probability of another RRR cut before the end of the year has fallen because of today’s moves. As a baseline case, we expect no cut before year-end.

The FOMC raised the funds target rate to 2¼% -2½%, as expected.  The median projected hiking path has now declined to 2-1 in 2019-20, down from 3-1 in September. Projections for 2021 continue to show no further hikes and the median dot at 3.125%. The long-run median dot declined to 2.75%, although this change was caused by only one dot moving down on net, as well as the addition of a new dot.

The post-meeting statement’s growth characterization was essentially unchanged—in contrast to our expectations of a modest downgrade—with overall growth “strong” and job gains, “strong, on average, in recent months.” The characterization of inflation was unchanged (“near 2 percent”), as expected. The most significant changes in the statement were to the policy guidance paragraph, which featured three arguably dovish changes. First, the “further gradual increases” language was modified to include “some,” though it retained “gradual.” Second, this guidance was prefaced with the less committal phrase, “the Committee judges,” rather than “the Committee expects.” Third, the balance of risks, which are still “roughly balanced,” saw an allusion to possible downside risks as the FOMC will “continue to monitor global economic and financial developments and assess their implications for the economic outlook.”

In terms of the economic projections in the SEP, the median GDP growth projection for 2018 edged down one tenth to 3.0%. The median 2019 GDP growth projection declined by two tenths to 2.3% and the 2020 and 2021 growth projections remained unchanged at 2.0% and 1.8%, respectively. The longer run estimate of potential growth increased one tenth to 1.9%. The projected path of unemployment remained unchanged in 2018 and 2019, with a one tenth increase in the 2020 unemployment projection to 3.6% and a one tenth increase in 2021 to 3.8%. The median longer-run unemployment rate projection edged down one tenth to 4.4%. The headline inflation projection for 2018 declined 0.2pp, reflecting “mark to market” effects after softer recent readings. Core inflation was downgraded by one tenth in 2018 to 1.9%, and, importantly, the 2019, 2020, and 2021 core inflation projections all declined by one tenth to 2.0% and no longer show an overshoot of the target.

The staff macro-economic projectionsembodied a small downward revision to GDP growth in both 2018 (-0.1pp to +1.9%) and 2019 (-0.1pp to +1.7%). The sequential growth profile shows growth at +0.4%qoq in Q4 and +0.5%qoq during the first three quarters of 2019, followed by a slowdown to a +0.4%qoq sequential expansion throughout the remainder of the forecast horizon. The December projections include an additional forecast year. GDP growth in 2021 is expected to be 1.5%. GDP growth forecast is close to the ECB’s projections. The Introductory Statement maintained that the risks to the outlook remain balanced, even if “the balance of risks is moving to the downside”. Underlying this assessment, Mr. Draghi pointed to risks stemming from geopolitics, protectionism, EM vulnerability and financial market volatility.

On inflation, the Introductory Statement text was broadly unchanged from October, stating that “measures of underlying inflation remain generally muted, but domestic cost pressures are continuing to strengthen and broaden amid high levels of capacity utilisation and tightening labour markets, which is pushing up wage growth”. Underlying inflation is still expected to increase gradually over the medium term supported by the ECB’s monetary policy measures.

The updated staff macroeconomic projections made some changes to the inflation forecast, Mr. Draghi noted the recent increase in wage growth − to +2.5%yoy in Q3 – and argued that it would support higher inflation in the future, even though the pass-through of wages into prices remains uncertain. The Governing Council confirmed that net new asset purchases would cease at year-end, as expected and in line with the plan Mr. Draghi outlined last June. Guidance on the reinvestment of principal on maturing bonds was left broadly unchanged. Mr. Draghi said that reinvestment would continue for “an extended period of time” after the first rate hike. The reinvestment will still take place ‘in any case for as long as necessary’. Mr. Draghi said, when asked, that the Governing Council did not discuss a more time explicit guidance on reinvestments.

As expected, an update on the technical parameters governing reinvestments was published. The ECB said that the allocation of bond holdings across eligible jurisdictions will continue to be guided by the ECB’s capital key and “as a rule, therefore, redemptions will be reinvested in the jurisdiction in which principal repayments are made, but the portfolio allocation across jurisdictions will continue to be adjusted with a view to bringing the share of the PSPP portfolio into closer alignment with the respective national central banks’ subscription to the ECB capital key”. Any adjustment will be gradual. The ECB added that limited and temporary deviations from the guidelines may occur for operational reasons and that reinvestments could be distributed over a twelve-month window “to allow a regular and balanced market presence”. Also as expected, the ECB’s principle of market neutrality will be maintained. The ECB did not implement a ‘twist‘, as some market participants had discussed.

 The forward rate guidance remains unchanged. The Introductory Statement reaffirms – in its ‘date dependent’ guidance – that the ECB expects policy rates to remain at their current levels “at least through the summer of 2019”. The current guidance still offers flexibility in terms of what will happen after the summer next year – the Governing Council maintains a ‘state dependent’ rate guidance (in addition to the date guidance), indicating that rates will be on hold for as long as necessary to ensure the continued sustained convergence of inflation. The ECB stands ready to adjust all its programmes if necessary, and Mr. Draghi said during the press conferences that the APP had become a permanent part of the tool box.Mr. Draghi received some questions on a possible new round of T-LTROs. He said that some members had mentioned this, but that it was not discussed in depth at today’s Governing Council.

With little new information offered at today’s press conference, our base case remains unchanged. Net asset purchases will cease by year-end. We expect the first rate hike to come in Q4 2019. We expect the first hike to be 20bp. We see a outcome for the ECB rate path, with  implying interest hikes in Q4 2019 and a pace of hikes of 25-45bp per year over our forecast horizon; our downside risk path has a first hike only by mid-2020 and a pace of hikes of 20bp-25bp per year .

In short, we expect the ECB’s Governing Council meeting in December to (1) confirm that net asset purchases are ending by year-end; (2) apply a dovish tone, by recognising rising downside risk and weak Q3 data (even if the ECB can look through this idiosyncratic dip), but stop short of downgrading the risk assessment from balanced to downside; (3) maintain its overall base case as laid out at the June Governing Council meeting; this scenario remains the single most likely path. But the probability of this scenario materialising has gone down in recent weeks, and we expect Mr. Draghi to give some indication of this.

We expect the following from next week’s Governing Council meeting:

We expect the overall monetary policy message to be that the June base case is in place but risks are present and the probability of the June base case has gone down. We expect Mr. Draghi to note the need for patience and prudence and, overall, attempt to communicate a dovish tone while still ending net asset purchases. While confirming the end of net asset purchases, we expect Mr. Draghi to emphasise next week that the Governing Council is monitoring incoming data and that the ECB’s rate path is state- dependent, implying that the ECB will, if necessary, respond to weaker inflation prospects by adjusting its forward guidance.