Fed: Pause and Recalibration (Mar. 17)

Mike & Co. —

If voters are uncertain and uneasy about the state of and short-term prospects for the economy, they are in good company. Surveying the indicators, the Federal Reserve voted yesterday to recalibrate before resuming its planned rate increases.   Its announcement reduced from four to two the number of such increases it expects this year. 

On balance, that is probably good news.  The Fed’s rate hike in December — the first since the financial crisis hit — and global economic conditions punished markets at the beginning of the year.  Investors and cash remain on the sidelines, or overseas, to an extent that applies brakes to the underperforming economy.   The Fed did not want to add another bump in the road.  

Below is a drill-down on the specific factors and data points that led to the Fed’s decision and what it portends. 

Best,

Dana

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The Fed — a Pause and Recalibration

The Federal Reserve’s March FOMC meeting is over and nobody is surprised at their announcement that rates will stay steady.  While further improvement in labor market conditions and the jump in core inflation means that the domestic economic data could have given the Fed all the excuse it needs to raise rates today, global concerns and an overall shaky stock market allowed the doves to win the day.

Economic Indicators and Forecast

The indicators listed in today’s announcement:

•   Inflation (CPI), the primary indicator the Fed looks to in making policy, is slowly climbing, up 1.25 percent in the twelve months ending January 2016, or 1.7 percent annually.   Core inflation (CPI less food and energy) hit 2.3% in February.
•  Unemploymenthas held at 4.9 percent through the first two months of the year — this factor, historically close behind inflation in significance to the Fed, is moving slowly into healthy if not robust territory

Those indicators led the Fed to revise its economic projections to the key measures below:

— median growth projection down from 2.2 to 2 percent in 2018

—  median unemployment projection shifts from 4.7 to 4.5 percent by the end of 2018

—  median inflation projection rises from 1.2 to 1.9 percent in 2017 and 2 percent in 2018

Statement Content and Meaning

The announcement is important in that it sets the monetary policy roadmap for the remainder of 2016, or at least that’s what observers will think.  The Fed’s dual mandate is to maximize employment while stabilizing prices – this has lead the FOMC to aim for 2 percent long-term inflation and unemployment around 4.8 percent.

The Fed’s decision indicates that it believes there is still enough slack in the U.S. economy to allow for a gentle glide path toward long-term rates.  This slack gives the group some cover to consider the global impact of their decisions – experts have warned that the emerging markets overfed on easy credit while interest rates were kept low, leading to a potential credit crisis abroad should interest rates spike.

Markets, both domestic and international, are continuing to react to the Fed’s announcement.  U.S. Treasury bonds slipped after the announcement, and the dollar weakened as commodities prices rose.  The Dow Jones and S&P 500 both saw a small rally to finish the day up 0.4% and 0.6% respectively.  Asian markets, which were perhaps the most worried of a rate hike, were buoyed upward by the Fed news.

Small Differences Magnified

Market turmoil has concerned dovish policymakers such as Governor Lael Brainard who warned last week that her colleagues “should not take the strength in the U.S. labor market and consumption for granted.”  Meanwhile, Fed Vice Chair Stanley Fischer has said, “we may well at present be seeing the first stirrings of an increase in the inflation rate.”  Chairwoman Yellen lies somewhere in the middle, and though she’s normally classified as a dove has been said to sympathize with the arguments of her more hawkish Governors as of late.

What lies between these two groups is the issue of how to weight different indicators in their economic models.  Doves are more likely to see global spillover from the Fed’s monetary policy as a limiting factor, as international demand drops and credit tightening abroad effects the US domestic economy.  Hawks are more likely to see the recent uptick in core-PCE inflation values as cause for concern.

The differences between these groups aren’t significant in the grand scheme of things, but they’re often played up in the media to represent a tug of war over the ear of the Chairwoman.  In reality the policymakers share opinions more often than not.  Today’s decision had only one dissenter.

Futures markets’ odds of the next rate hike occurring in June fell from 66 to 38 percent yesterday afternoon.  That is the sound of the markets breathing a sigh of relief.  The Dow finished the day at its highest close of the year.