**MNI PRE-FOMC: June Hike Inches Fed Closer To Neutral

--FOMC Expected To Raise Interest Rates 25 Basis Points

--IOER May Be Increased 20 Basis Points, Below Top Of FFR Range

--Forward-Guidance Language Could Be Modified To Signal Policy Closer To Neutral

By Sara Haire

     WASHINGTON (MNI) - Continued momentum in the economy is expected to

underpin another quarter-point interest rate increase as the Federal Open Market

Committee concludes its meeting Wednesday, bringing the target range to 1.75% to

2.00%. But more telling will be how the FOMC alters its forward-guidance

language to signal policy has moved closer to neutral.

     The minutes of the previous meeting indicated that if incoming information

continues to show a growing economy, it would "likely soon be appropriate for

the FOMC to take another step in removing policy accommodation."

     Adding to the strong economic outlook, rising inflation and balanced risks

have some analysts speculating the FOMC's quarterly update of its Summary of

Economic Projections will show a shift to four hikes total in 2018 versus the

three expected in March. However, the Fed is just as likely to hold off on the

move as it waits to see how the Trump administration's fiscal stimulus, as well

as its trade negotiations, play out.

     The FOMC is likely to implement its 25 basis point rate hike with a 20

basis point increase in the interest it pays on excess reserves, keeping that

rate below the top of the fed funds range.

--DOTS MAY STAY

     Economic activity is likely to ramp up in the latter half of the year

spurred by tax cuts and higher federal spending caps. As of June 6, the Atlanta

Fed's GDPNow forecast saw second quarter GDP growing at 4.5%, which would be the

highest rate recorded since 2014. Inflation is also expected to accelerate, with

the Cleveland Fed's Nowcast predicting core PCE inflation to hit 1.9% in the

second quarter, up a tenth from March and April.

     But Fed officials in their May meeting hinted that they are open to

allowing the economy to run hot temporarily, especially since inflation has not

yet been sustained at the Fed's 2% "symmetric" objective. Some policymakers have

even said a temporary overshoot of inflation may help raise longer-run inflation

expectations.

     At the same time, average hourly earnings in May rose only 2.7% from a year

earlier despite the unemployment rate falling to a fresh 18-year low of 3.8%,

showing the labor market tightness is not yet showing signs of overheating. This

should signal that the median projection in the SEP for the longer run rate of

unemployment is unlikely to be revised based off of a few months of strong labor

market conditions, but even a tenth of a percentage point shift down is unlikely

to indicate a faster pace of rate hikes.

     Risks to the outlook appear to be balanced still. The FOMC could mention

the potential for geopolitical developments or trade policy uncertainties to

pose a downside risk to the outlook, but are unlikely to address specific

policies in the statement.

--GRADUAL MOVES FORWARD

     Given the expectation for the economy to ramp up, gradual interest rate

increases remain appropriate, something a number of Fed officials have argued in

days leading up to the June meeting.

     The statement is unlikely to change their outlook for "further gradual

increases" in the fed funds rate, given most policymakers have voiced their

support for gradual increases remaining appropriate.

     However, as interest rates continue their march up, policymakers have

recognized that the forward-guidance language introduced a few years ago that

"the federal funds rate is likely to remain, for some time, below levels that

are expected to prevail in the longer run" is "growing stale," according to Fed

Governor Lael Brainard.

     Some officials have suggested that it be replaced with a more detailed

explanation of the Fed's reaction function, though it is unclear if the FOMC has

given that a thorough consideration as yet.

     Brainard also mentioned that given continued strength in the outlook, the

policy path could move even past neutral "and after some time, modestly beyond

neutral." However, the apparent range of opinions on how much higher the FOMC

should push rates above neutral, evident from the May minutes, means the

committee is still far from consensus on that important question.

--IOER

     The 25 basis point increase in the Fed's target range is likely to be

accompanied by a smaller-than-usual 20 basis point rise in interest on excess

reserves, a technical adjustment meant to help the FOMC implement monetary

policy.

     Since the target range was established in December 2008, the IOER rate has

been set at the top of the target range to help keep the effective federal funds

rate within the range. But recent funding pressures have narrowed the spread

between IOER and the effective fed funds rate to only 5 basis points.

     As the May meeting minutes revealed, "Many participants judged that it

would be useful to make such a technical adjustment sooner rather than later,"

and officials "generally agreed that it would be desirable to make that

adjustment at a time when the FOMC decided to increase the target range for the

federal funds rate."

     The tweak would restore breathing room for the effective fed funds rate,

ensuring the Fed retains firm control over its policy rate. And making the

adjustment without delay would also give the Fed a chance to learn more about

the effect of the tweak on markets and rates. 

--MNI Washington Bureau; +1 212-800-8517; email: sara.haire@marketnews.com

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