Although the Federal Open Market Committee decided to maintain the federal funds rate at its current level, its latest communications confirmed that labor-market conditions continue to improve and the broader economy continues to expand at a moderate rate. Its decision to keep rates static focused on two key issues: low inflation and international events.
Highlights of the Fed’s Latest Communications
Key quote: “Monitoring developments abroad”
The events in China this summer seem to have had a significant impact on the FOMC. In her press conference, US Federal Reserve Chair Janet Yellen mentioned China’s economic and financial volatility and noted the need to carefully watch the interconnectedness between international conditions and the US economy. In addition to reiterating that domestic risks are “nearly balanced,” one new phrase appeared in the FOMC statement that we haven’t seen in the past: The FOMC is “monitoring developments abroad.”
Unsatisfied with inflation
The FOMC admitted in its latest statement that non-US economic and financial conditions have in turn put downward pressure on US inflation. Although the statement suggests that the FOMC believes that the non-US influences on US inflation and growth will prove temporary, Chair Yellen said during her press conference that inflation is still not close to where the Fed would like to see it before raising rates.
The Committee continues to look at a variety of measures of inflation and inflation expectations; accordingly, market-based measures moved lower while survey-based measures of long-run inflation expectations remained stable. That was clearly not enough to move the Fed. As has been the case after previous meetings, the latest statement confirms the FOMC’s view that inflation remains below target—but the Committee has confidence that it will rise eventually.
Mundane message was meant for markets
The FOMC’s new statement was notable for its general blandness, as we had anticipated, with very little change in wording from the previous announcement. By keeping the statement bland, the Committee avoids roiling the markets via verbiage. Its message was intended to inform the markets—not analyze it.
Fed is focused, not fixated
Yellen admitted directly that uncertainty abroad and weak inflation were key factors in the decision. However, she reiterated that policy would not be determined by an over-emphasis on any singular data point, or by any one country.
Factions forming within the FOMC
It’s becoming clear that this is an FOMC with increasingly divergent views. We saw that four participants do not expect that conditions will warrant a fed funds rate increase this year, while five would like to see rates finish the year at 0.625%—a big leap from where we are today. We also learned of one dissenting vote—the president of the Richmond Fed, Jeffrey Lacker—which ended a streak of five consecutive unanimous votes for Yellen. All told, it seems that Yellen will keep having to straddle two very different camps within the FOMC—and will need to try hard to move them toward the middle.
Forecasts: Dots, Unemployment, Inflation and GDP
FOMC dots
Not only did policymakers decide to hold rates steady, but they downgraded their recommendations for future rate hikes as well. The median recommendation for the end-2015 fed funds rate was trimmed from 0.625% to 0.375%. This suggests that—given the current effective rate of roughly 0.13%—policymakers still envision a single 25-basis-point hike at either the October 27-28 or December 15-16 FOMC meetings.
- One Committee member recommended a -0.125% rate this year. This is the first time we’ve seen a negative rate recommendation, but Yellen also suggested it should not be taken seriously.
- Three members recommended to not change policy through year-end.
- Seven members suggested a hike to 0.375%.
- Five recommended a move to 0.625%.
- One member suggested increasing rates to 0.875% by December 31. Given his dissenting vote for a hike today, this final point on the “dot plot” was probably placed by Jeffrey Lacker.
Of course, as we have reiterated in the past, the path of future rate hikes is far more important than the date of liftoff. On that point, the new dots suggest a slower rate-hike cycle than previously conveyed, with downgrades in the recommended year-end policy rate for 2016 and 2017.
Of note, policymakers reduced their forecast for the longer-run fed funds rate from the previous 3.3% to 4.3% range to the current 3.0% to 4.0% range. This may mean that the FOMC sees that the terminal rate during the upcoming rate hike cycle will be lower than it has been during previous cycles. If so, while the projected slope of rate hikes still looks fairly slow, the cycle may end earlier than previously thought.
Unemployment projections
Unsurprisingly, policymakers further reduced their forecasts for the unemployment rate. Back in June, they expected it would end 2015 between 5.2% and 5.3%. But we blew past that number almost as soon as it was released, with unemployment in August at 5.1%. The new forecast for 2015 is now 5.0% to 5.1%.
Beyond 2015, today’s projections suggest that policymakers expect lower rates of unemployment in coming years—and in the longer run as well. In fact, the unemployment forecasts for 2016 and 2017 of 4.7% to 4.9% are slightly below the FOMCs longer-run forecast of 4.7% to 5.0%. This suggests that policymakers may believe that, in the current environment, unemployment could temporarily fall below the long-run natural rate of unemployment without generating too much inflation.
Headline inflation projections
With regard to inflation, the new FOMC projections show weaker estimates for 2015, 2016 and 2017.
- For this year, policymakers downgraded their estimates from 0.6% – 0.8% in June to 0.3% – 0.5% currently.
- For 2016, estimates were cut from 1.6% – 1.9% to 1.5% – 1.8%.
As Chair Yellen mentioned during her press conference, some of the decline in expected inflation is tied to ongoing downward pressure in commodities prices coupled with the strength in the US dollar. Our own analysis suggests that, while base effects may result in an increase in the annual rate of inflation in coming months, the continued retrenchment in energy prices may mean that any base-effect increase is temporary, with more disinflation to follow.
GDP projections
Policymakers increased their projections for 2015. This was partially due to—as Chair Yellen noted during her press conference—the recent release of upgraded estimates for the first half of the year. The 2015 forecast now stands at 2.0% – 2.3% compared with 1.8% – 2.0% in June.
However, policymakers now anticipate weaker growth for both 2016 and 2017. Next year’s forecast was trimmed from 2.4% – 2.7% to 2.2% – 2.6%. The 2017 forecast was cut from 2.1% – 2.5% to 2.0% – 2.4%.
Investment Implications
While markets initially experienced a relief rally on Thursday, stocks have been moving lower overall as investors process the underlying conditions that caused the Fed to sit on its hands. We expect this trend to continue and, as a result, expect risk assets to move lower in the coming weeks—but this could be a relatively short-term development.
We also believe that uncertainty about future Fed policy will increase, given that we’re seeing new market and foreign developments in reaction to the Fed’s inaction. The risk of higher volatility once the Fed raises rates has increased, as has the risk of policy error—that is, staying too low for too long.
In this environment, we recommend that investors look for opportunities to add to their risk assets, which we believe will be in favor given overall monetary policy.
Investors should also prepare for the first rate hike. That means a selective reduction in emerging-market exposure, given the potential for capital outflows from emerging markets once the Fed begins raising rates, and a reduction to core-bond allocations, given the potential for capital depreciation.
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