Time and time again investors hear the refrain, “don’t fight the Fed” and take positions in opposition to their communications. Importantly, to fight the Federal Reserve Bank, one must assume their communications are clear. Leading up to last week, Chairwoman Yellen took great pains over several months to communicate the Committee would be data dependent, the labor market was very close to full employment and fully healed since the financial crisis of 2008, and that improvements in a comprehensive set of inflation measures were necessary to continue the rate normalization begun in December 2015. Market participants assumed the financial market volatility experienced the first six weeks of the year would prevent a hike at the March meeting but that solid progress towards both the full employment and price stability mandates would solidify expectations for a further rate hike at the June meeting.
Instead, message from the March Federal Open Market Committee (FOMC) meeting revealed a Committee that is much more attuned to risks emanating from abroad and likely to take a much more cautious approach to policy normalization. For example, while the policy statement did not bring back a full assessment of the risks to the outlook, it nevertheless noted that “global economic and financial developments continue to pose risks”. The Chair elaborated on these risks in her press briefing, highlighting a number of countries experiencing slower growth. Despite the firming in inflation over recent months – year over year core personal consumption expenditure rose to 1.67% in March, above the 1.6% end of year level in the Summary of Economic Projections – the policy statement continues to emphasize that inflation is running below the Committee’s objective, and that it is expected to remain low in the near term. Moreover, at 4.9%, the U-3 unemployment rate had fallen to the Committee’s projected long run level, until they lowered it for the third time in 12 months to 4.8%.
Judging from the median economic projections, the Committee continues to anticipate above-trend growth this year and next, and a gradual return of inflation to two percent. However, to achieve these outcomes, Committee members anticipate a notably flatter path of policy rates. The median policy rates projected for year-end 2016 and 2017 each came down by 50 basis points, to reflect 50 basis points of policy tightening this year and 100 basis points next year. In response, yields fell across the Treasury curve, most notably in the shorter-term maturities as investors covered short Treasury positions. In addition, global equity markets rallied, credit spreads narrowed, the trade weighted US dollar weakened, oil prices and breakeven inflation rates rose, and various volatility measures subsided.
Some have suggested the more the Fed tries to communicate, the more confused investors become. However, as we have stressed repeatedly, the FOMC must consider the second and third order effects of its policy in a world of essentially unimpeded global capital flows and increasingly global price competitiveness. While domestic data surely improved during the intermitting period, the period was also characterized by: 1) significant spikes in equity, foreign exchange and fixed income market volatility to levels not seen since the Lehman crises; and 2) monetary easing by the Reserve Bank of New Zealand, European Central Bank, People’s Bank of China, and the Norges Bank. As a result, some acknowledgment of the fragile global growth environment and related risks to the US economy was surely warranted at the FOMC March meeting. As for the timing of an additional rate increase, June remains a possibility. The Committee will want to see that the recent firming of inflation does not prove short-lived, and that inflation expectations continue to move higher. They will also seek confirmation that domestic growth is not slowing to a below-trend pace. In this regard, some of the key variables to watch include payrolls, consumer spending – which has been running on the soft side recently – and surveys of service sector activity. In addition, a rebound in global growth momentum reflected in indicators such as global PMIs would be supportive of further US rate normalization.Download to read more