The Fed strikes the right balance
But be careful analyzing rate move as dovish
The knee-jerk reaction to the U.S. Federal Reserve’s rate hike, which boosted the fed funds rate target range by a quarter point to 0.25 to 0.5 per cent, is that it delivered a dovish one. I’m not so sure about that. For one, the Fed did not reduce its median “dot” for 2016, which stayed at 1.375 per cent. The futures market is still priced for roughly two rate hikes next year and the Fed is telling you that there is still closer to four moves (as in, skipping every other meeting) to come.
There is not a snowball’s chance in hell that the two-year U.S. Treasury note remains at one per cent if the Fed is going to take the fed funds rate target up to 1.375 per cent next year and 3.5 per cent for the estimated neutral level (ditto for the 10-year Treasury note remaining near 2.2 per cent).
Second, the Fed dramatically boosted its assessment of the labour market: “A range of recent labour market indicators, including ongoing job gains and declining unemployment, shows further improvement and confirms that underutilization of labour resources has diminished appreciably since early this year.”
And, for good measure, it added that it expects labour market indicators “will continue to strengthen” and that it expects inflation to rise to two per cent over the medium term “as the transitory effects of declines in energy import prices dissipate and the labour market strengthens further.”
The Fed could scarcely be more adamant that the labour market part of the mandate has been achieved.
The reason why some pundits see this as a dovish outcome is because the press statement said “In light of the current shortfall of inflation from two per cent, the Committee will carefully monitor actual and expected progress toward its inflation goal.” This was clearly a de facto bribe to the three voting doves — Lael Brainard, Daniel Tarullo and Charles Evans — to get them to support the rate hike, which they did (the decision was unanimous).
The Fed has met the full employment objective, but there still are some who are worried about continuing to fall short of the inflation target even as core CPI inflation just retested the two per cent mark for the first time in 18 months.
Talk about cognitive dissonance. After all, the Fed cannot control the price of oil, but what it can control is already at the target.
The Fed did say future rate increases will be “gradual,” but remember that they used the term “measured” in June 2004 when it hiked for the first time in nearly a half decade, and then proceeded to tighten by 425 basis points in a two-year span.
Gradual is already embedded in the Fed’s published forecasts, by the way, and the bond market is still not completely priced for what is likely to come if the Fed proves prescient (yes, history shows this is a big if ).
And yes, the Fed reiterated that in addition to the data, it will be influenced by “readings on financial and international developments.” This is very similar to what the Fed stated at its Oct. 28 meeting.
What is just as important is that Fed policy, even after the hike and all the associated tightening coming out of the high-yield corporate bond market, is still viewed as being “accommodative.”
There was no mention of any changes to the size of the balance sheet, but the markets were not looking for any shift on this score in any event.
Also, keep in mind what the Fed did not mention this time.
It did not mention concern over global events. In aggregate, the risks were seen as being “balanced,” not at all skewed to the downside. It did not discuss oil prices. Emerging-market angst was not mentioned.
Any reference to a strong dollar was missing.
The sharp energy-related correction in the high-yield market was ignored.
Nothing in the financial conditions has tightened.
Sometimes what is left unsaid matters just as much as what is said, which is another reason I don’t look at the Fed’s statement as being as dovish as what the narrative has been thus far.
The positive reaction in the stock market and stable bond market, as well as the muted reaction in the currency market shows that the Fed has found its footing and dramatically improved its communication skills with the investment community.
And, quite frankly, moving away from the zero-interest-rate policy has to have everyone at the Fed feeling jubilant. I can only imagine what the holiday party mood is going to be like this year, but I expect it will be quite festive (no more spiking the punch bowl, however). This is not a repeat of 1937-38. The markets are handling the rate increase with panache — a far cry from the confusion and stock market reversal back on Sept. 17 — and I do not expect any negative economic fallout either.
If anything, the Fed should have started this campaign earlier this year, but the initial negative Q1 GDP reading scared it off.
Looking at the balmy weather, the coming Q1 GDP performance figure is very likely going to provide an upside surprise — as we saw in the surge in housing starts in November.
The U.S. dollar is strong, but it already peaked on a trade-weighted basis, and if commodity markets ever manage to stabilize, we are going to end up having goods inflation flatten out. Combine that with core services inflation heading quickly to a three per cent trend and it points to the Fed shifting its concern toward preventing underlying trends from moving through two per cent to the upside.
I know this sounds ludicrous because human nature is such that we tend to extrapolate the most recent experience into the future, but let’s go back to 2003 when core inflation was near one per cent, oil was at US$30 per barrel and Ben Bernanke was giving speeches about deflation and unconventional policy measures. Who would have thought back then that in less than three years’ time, core inflation would be challenging the three per cent threshold and that oil would see $70 US per barrel.