When in doubt, my dear fellow, do nothing

It was undoubtedly this quote that guided the members of the Monetary Policy Committee (FOMC) of the FED.

The press release from the Fed is slightly more positive regarding the US domestic growth, notably upgrading its assessment of the investment. However the risk that “the recent global economic and financial developments” (in China and other emerging markets) caused a slowdown in economic activity and lowered inflation also weighed.

A “dovish” FED

Just like the FED’s forecasts, the press conference took a very “dovish” tone. While growth has been revised upwards for 2015, it was slightly revised downwards for 2016 and 2017. Thirteen members anticipate an increase by the end of the year against fifteen in June. Along with the policy decision statement, the FED releases a dot plot which shows where each participant in the meeting thinks the federal funds rate should be. The dots were revised downwards for most FOMC members and some points even appeared in negative territory. This implies that one member of the FOMC is very concerned but it also means that, if necessary, the Fed would probably prefer negative interest rates to a new quantitative easing program.

Nevertheless, despite these very accommodating elements, Janet Yellen emphasized that a rate hike was discussed and that each meeting would be “live” by the end of the year, that is to say that a decision to raise interest rates may be taken. She also explained in the press conference that the impact of recent events should not be overplayed and that they did not change the outlook on the US economy. Therefore the main reason behind this immobility is indeed uncertainty.

A “symmetrical” objective

From a more fundamental perspective, Janet Yellen recalled that the Fed’s inflation target is symmetrical. She will not tolerate an inflation being either much below or above its target. While in her programmatic speech in April 2015, she relativized the importance of inflation, she placed greater emphasis on the matter this time. She also stressed that the path of hikes may be steeper or flatter than forecasts based on published figures.

We thought a rate hike was both probable, in light of the improved economic conditions, and necessary to reduce uncertainty and so that the markets would stop focusing on this issue. In view of the elements above, the date of the first increase will probably be postponed to December.

Markets partially adjusted to these more favourable conditions. Nevertheless, we would like to make four comments on the extremely dovish position taken by the Fed:

  1. The Fed’s forecasts indicate that the unemployment rate will stabilize next year at 4,8% for the next three years while it is currently at 5,1% and has declined on average by almost 1,0 % per year over the last four years with an average economic growth equal to 2,2%, the level of growth expected over the coming years. What will the reaction of the Fed be if the unemployment rate continues to fall rapidly?
  2. What will the other central banks do ? It is now very likely that the ECB and the Bank of Japan will increase the size of their quantitative easing.
  3. The Fed wants to avoid making the mistake of tightening monetary conditions too early, but being paralyzed by fear and waiting may create the conditions it wants to avoid, that is a sharp rise in long term interest rates. In our brief on the 21st of April 2015, we noted that the Fed had two options : an early but gradual increase and a later but faster rise. In the event of an acceleration in wages and inflation, the FED would be forced to act quickly whereas if it had already begun raising rates, it could have maintained on a very progressive stride, while emphasizing on the delay between rate hikes and their impact on the economy. The impact on long term interest rates would undoubtedly be important.
  4. While 13 members out of 17 expect a rate hike by the end of the year, the market believes that the probability is less than 50%. At the end of 2017, the market sees the Fed Funds at 1,30% while the midpoint in FOMC forecasts is 2,50%. By systematically reviewing downwards its forecast, the Fed has put itself in a dovish position leading the market to no longer believe what she says and is consistently dovish, forcing the hand of the Fed.

To date, inflation remains low but the likelihood rises that we will observe a marked acceleration in wages and in inflation.

Monetary policy is like piloting an ocean liner whose course cannot easily be altered. Turns must be initiated well in advance to avoid obstacles, even though we are unsure we will encounter them. If, as we believe, the labor market remains much more dynamic than the FED’s forecasts, the time will come when the wage-price loop will set off. Market expectations exclude such a scenario even though it falls under the conventional economic logic.

Equity markets have often been accused of succumbing to the lure of “This time is different!”. This time it may well be the turn of bond markets to give in. However, for the later, the awakening may be brutal!


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