Is the Fed slipping into bad habits?

In the absence of rate rises at the FOMC’s meeting on March 16th, its members and Chair, Janet Yellen, managed to surprise the market by adopting a particularly dovish rhetoric and by lowering policy rate expectations on the ‘dot plot’. Whereas four increases had been implied for 2016, there are now just two, and no catching up in subsequent years is predicted, with the four-per-year pace being maintained. The long-term rate was cut to 3.25%. Indeed, the Committee seems to have slipped into the habit, since late 2014, of lowering its forecasts (see Figure 1).

Another downward revision for the Fed funds rate path

As always, the market magnified the Fed’s lower expectations for the path of policy rates. The probability priced in by the market of none or just one rate increase rose from 58% the day before the Fed meeting to 75% the day after. If the Fed was hoping to gain credibility with forecasts more in line with the market’s, it will have to try harder.

The Federal Reserve apparently intends maintaining a very accommodative policy, even though according to some classical models, such as those derived from the Taylor rule (see Figure 2) the Fed funds rate should have started to rise from early 2014 to have reached between 3.5% and 5% by now, depending on various estimates. These models are, of course, probably not fully adapted to a backdrop of recession recovery and exceptional financial crisis, but even Janet Yellen’s once favoured optimal control approach shows that the Federal Reserve should have begun raising its rates mid-2014 to bring them to 1.75% in the first quarter of 2016.

Janet Yellen’s speech at the press conference reinforced the dovish message. It therefore seems that market volatility in recent months, tighter financial conditions and concerns over the global economic environment have overshadowed job market momentum and the first inklings that wages and inflation are gaining pace. In fact, Janet Yellen warned that the shifts in wages and inflation were being influenced by temporary factors.

A rather uncertain economic scenario

Growth forecasts were revised marginally downwards for 2016 and 2017 to 2.2% and 2.1% respectively (fourth quarter, year-on-year). The long-term growth forecast remains 2.0%. The unemployment rate should continue to fall gradually to reach 4.7% by the end of the year and then 4.5% by the end of 2018. The longer-run unemployment projection was edged down to 4.8%. Core inflation forecasts, however, were not revised.

Janet Yellen’s more qualitative comments indicate that growth remains very robust despite a complicated backdrop, but that there is still room for improvement in the labour market.

Overall, the Fed expects stable growth compared to 2015, which should help sustain a gradual improvement in the labour market and inflation. Whilst in December the monetary policy committee felt confident enough to talk of balanced risks, at this meeting Janet Yellen insisted several times on reduced economic certainty, as well as on breakeven Fed fund rates.

Proceed with care

Last December, Janet Yellen mentioned that in addition to the usual business and labour market data, the FOMC would be paying more attention to inflation levels, including both the expected and actual figures. As previously mentioned, the upturn in inflation observed over the last two months was tempered (see Figure 3), whilst the low inflation levels expected by the market were foregrounded. The Fed’s favourite indicator, the 5-year 5-year forward breakeven inflation rate, remains at an extremely low level of 1.5%, far from its average until 2014 of around 2.5%.

Committee members therefore believe that reaching

the aforementioned growth levels, which are similar to December’s forecast, implies a lower Fed funds rate path. This caution in monetary policy tightening should help “ensure that the labour market continues to improve despite the external risks”. This translates a certain degree of asymmetry in Janet Yellen’s approach, given that with rates close to zero, monetary policy can be more easily adjusted in response to an improvement in economic circumstances than to a deterioration. Some of Janet Yellen’s comments during the press conference suggest that the Fed will be relatively tolerant if inflation breaks through the 2% threshold. The inflation goal, she pointed out, is symmetrical. That said, Chair Yellen indicated that the central bank did not intend to implement support measures and that negative rates were not on the agenda. The next moves are therefore likely to be rate rises.

A meeting that leaves room for interpretation

The first interpretation is that the committee’s monetary policy is more dovish than previously imagined. The FOMC seems willing to tolerate slightly higher inflation for a while and might even be trying, albeit discreetly, to achieve just that. The FOMC’s economic forecasts appear to be inconsistent with the unemployment rate. With a growth rate equal to the past five years’ average, or 2%, around 200,000 job creations per month can be expected. The Fed, however, estimates that 75,000 jobs per month would be enough to cause the unemployment rate to fall. If these forecasts were consistent, then unemployment rate forecasts should continue to fall sharply, whereas the near-stability in the unemployment rate predicted by the Fed ties in better with a very gradual rise in inflation and interest rates.

The second possibility is perhaps that the very high current levels of uncertainty could explain the Fed’s attitude. Janet Yellen insisted that Fed members’ forecasts could be revised upwards as well as downwards. Given the appearance of negative factors in recent months, the FOMC members have preferred to revise their forecasts downwards, but if the situation were to improve, they would undoubtedly revise them upwards as was indeed the case in 2014 (see Figure 1).

A third interpretation could be that concerns over global financial stability are being factored into the Fed’s monetary policy. Mindful of not adding to emerging countries’ woes, the Federal Reserve is maintaining its more accommodative slant to monetary policy, that domestic arguments alone struggle to justify, in order to avoid higher interest rates and an overly strong rise in the dollar. The Federal Reserve perhaps feels limited by the increasingly accommodative policies of the ECB and BOJ. If the rate differential becomes too marked then this could cause an excessive rise in the dollar, which would be damaging for the US economy.

Finally, the Fed probably wants to avoid upsetting the bond market for fear of causing a bond crash. By maintaining very low short-term rates despite rising inflation, the Fed may be looking for the curve to steepen, leaving long-term rates to rise gradually before raising the Fed funds rate.

Reality is notoriously complex and each of these different interpretations is valid to a certain extent, but they call into question the clarity of the Federal Reserve’s monetary policy. This may be deliberate. While clarity in central bank’s intentions is sometimes necessary for their measures to generate results, at other times a certain ambiguity may help to keep all options open. After all, as Alan Greenspan once said, “I know you think you understand what you thought I said but I’m not sure you realize that what you heard is not what I meant”.

A cautious monetary policy in the short term but risky in the medium term?

Investors applauded the Fed’s announcements. The US equity market has regained its losses from the beginning of the year. The dollar fell against all currencies. The ten-year rate is down slightly (-7 bps to 1.9%). The markets are decidedly anticipating very low inflation for several years to come. Indeed, according to inflation swaps, it is only expected to exceed 2.0% in 2024 (see Figure 5).

In taking such a dovish stance, the Fed is undoubtedly meeting market expectations, but the absence of inflationary risk in recent years does not mean that it has disappeared. The ongoing uptick in inflation cannot be explained by housing prices alone (see Figure 3). Aside from energy prices themselves, inflation has probably been depressed by lower oil prices. If the labour market continues to tighten rapidly, wages should rise faster. The latest data published for March, by Empire surveys and the Philadelphia Fed, suggests that the manufacturing sector is beginning to recover. Several headwinds to growth, such as public spending and household deleveraging, are easing. For all of these reasons, there is a likelihood that US growth will accelerate in 2016.

Conclusion

How will the Fed react if growth proves stronger than the expected 2.0% and if inflation continues to gain pace?

In 2015, the monetary policy committee’s options were either to

1. raise rates sooner than expected in order to be able to do raise them more gradually, or;

2.wait and run the risk of having to raise them more swiftly, potentially causing panic in the bond market and hampering growth further.

On the one hand, falling behind on the annual path of about four 25 basis point rises per year, which would have been the slowest normalisation cycle in the Fed’s history, means the US central bank is likely to find itself in precisely the situation it was trying to avoid.

On the other hand, Janet Yellen repeatedly stressed that the forecasts could be revised in the course of the year.

Our economic scenario, based on US growth strengthening in the coming months and on inflation remaining on the right track should, we believe, lead the FOMC to reconsider the situation in June. We still believe that three rate rises are possible by the end of the year.