Written exclusively for InTouch Capital Markets
31st January 2018
By Steven K. Beckner
Federal Open Market Committee statements have seldom been known for effusive economic pronouncements or dramatic rhetorical shifts. There’s a studied gradualism to how the FOMC’s monetary policy assessments evolve.
The Federal Reserve interest rate-setting body’s explanation of why it is leaving the federal funds rate unchanged in a 1.25% to 1.5% target range is in keeping with that tradition. The statement looks rather restrained relative to the U.S. economy’s recent impressive record of achievements.
But there are noteworthy nuances acknowledging the economy’s improved performance.
The FOMC, with Janet Yellen chairing for the last time before giving way to Jerome Powell, met amid stronger growth and prospects of more thanks to deregulation and a $1.5 trillion tax cut. They met amid tightening labor markets, evidenced by December’s bigger than expected 234,000 private sector job surge; signs of incipient, if belated, inflation pressures; record-breaking stock gains (barely dimmed by recent fluctuations), and rising bond yields.
Against that backdrop, the FOMC now says “the labor market has continued to strengthen and that economic activity has been rising at a solid rate. Gains in employment, household spending, and business fixed investment have been solid, and the unemployment rate has stayed low.”
By contrast, the less upbeat Dec. 13 statement said household spending had been “expanding at a moderate rate” while business investment had merely “picked up.”
The FOMC also sounds a bit more encouraged on inflation: “On a 12-month basis, both overall inflation and inflation for items other than food and energy have continued to run below 2 percent.” In December, it said both inflation measures had “declined.”
And whereas the December statement said “market-based measures of inflation compensation remain low,” the new statement observes that “market-based measures of inflation compensation have increased in recent months but remain low.”
In another notable change, the FOMC said, “The Committee expects that economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate.” Note the addition of the word “further.”
Together these changes suggest movement toward less concern about low inflation and more confidence the economy can withstand further withdrawal of monetary accommodation. FOMC participants may not be quite ready to make substantial upward adjustments to their economic forecasts or federal funds rate projections. But then they don’t have to formally make those determinations until the March 20-21 meeting. By then officials, most of whom like to wait for convincing evidence, will have more data under their belts. Like Rome, monetary policy decisions aren’t built in a day; they are the result of months of accumulated evidence and consensus-building.
In the weeks leading up to the meeting several Fed policymakers suggested upside risks now exceed downside risks, mentioning the possible need for four 2018 rate hikes, rather than the median three in the December dot plot. But the latest statement reiterates that “near-term risks to the economic outlook appear roughly balanced.”
An asymmetric change to the balance of risks, which could come at future meetings. would be highly significant.
Despite much recent talk about changing the “monetary policy framework” due to concerns about persistent undershooting of the 2% inflation target, the FOMC did not change its Statement on Longer-Run Goals and Monetary Policy Strategy — possibly because inflation data have become more favorable. The FOMC reierated its “symmetric” 2% target. But we probably haven’t heard the last of proposals to shift to price level targeting or some other alternative approach, though.
Fed, Markets More in Synch on Interest Rate Outlook
At the outset of the meeting, futures markets were putting 88% odds on a March rate hike and were projecting three rate hikes over the next 12 months, indicating market expectations are now more in line with FOMC projections, whereas in the past the market often anticipated fewer rate hikes. As one expert explained, this is “simply representative of the fact that the risks are now more symmetric.”
“Previously, the Fed’s modal forecast (dots) said 3-4 hikes but everyone knew 0-3 hikes were way more likely than 4-7 hikes,” he continued. “Thus, the market’s (probabilistic) forecast was consistently below the Fed’s (modal) median.”
“Now those risks are more symmetric,” this source at a prominent Wall Street firm went on. “Four is perhaps more likely than 2. However, 2 is still more likely than 5 (and probably even 1 is more likely than 5). So while some asymmetry still exists, it’s more balanced than previously.”
He added that “the market is also pricing some chance of the median dot going up in March, so the December dots are a little bit ‘stale’ at this point.”
If recent signs of vulnerability in global stock markets continue, thereby firming financial conditions, that could reduce Fed proclivities to make offsetting rate hikes. But of course stocks pulled back from very high levels before rebounding on FOMC day, and it remains to be seen whether stocks have a lasting sell-off.