14 Juni 2018
The Federal Reserve’s Federal Open Market Committee (FOMC) concluded its two-day meeting today by raising interest rates by 0.25 per cent, with the Fed Funds target rate range now 1.75 per cent to 2 per cent. This was widely expected by the market. While the accompanying statement and press conference didn’t deliver much new information, the Fed upwardly revised its economic projections, which led to a stronger dollar, higher U.S. Treasury yields, and a weaker equity market immediately after the announcement.
The statement in detail
The key change in the monetary policy statement was the removal of forward guidance. The Fed now believes that the interest rate is close enough to its normal level that policymakers no longer need to communicate about being below long-term levels.
This doesn’t mean an end to rate rises: Another three or four hikes are required to reach the terminal rate. But it does tell us the Fed is thinking that it has broadly neutralised policy.
The Fed made a slight adjustment to the Interest On Excess Reserves (IOER), raising it by only 0.2 per cent. This is to ensure the effective Fed Funds Rate stays within the target bounds. While this is a technical issue, it does point to the difficulty in implementing monetary policy in an environment of excess reserves. The Fed will undoubtedly continue draining its balance sheet, regardless of the recent objections by some EM countries.
The projections in detail
The most hawkish element of today’s FOMC meeting was the upward revision to economic projections for 2018: its GDP forecast was raised to 2.8 per cent from 2.7 per cent; unemployment was trimmed to 3.6 per cent from 3.8 per cent; and its inflation expectation was increased to 2.1 per cent from 1.9 per cent.
The Fed now expects four rate rises this year, up from its previous prediction of three. This will be played up in media headlines but in reality, it was a very marginal change. Excluding outliers, previously six FOMC participants expected three rate rises in 2018 and six expected four. Just one of those expecting three now expects four, which was enough to push up the medium.
Similarly, rate expectations for 2019 were raised to 3.125 per cent. While this is only 0.25 per cent higher than the previous forecast, it is significant because the Fed’s belief that the long-term level of rates is 2.9 per cent implies that monetary policy will become restrictive sometime during 2019.
Analysing the press conference
The Federal Reserve announced that it will hold press conferences at every meeting, starting from next year. That doesn’t change monetary policy but does make all eight of the annual FOMC meetings equally likely to bring interest rate changes. I think this structure would be more useful if economic growth deteriorated and emergency cuts were needed. Some market commentators believe its near-term use is to enable more rate rises, but I doubt that.
Chair Powell confirmed that the recent oil price rise will only have a transitory effect and hence the Fed won’t respond to it.
The Fed has observed that companies are experiencing labour shortages but it remains a puzzle why this hasn’t led to wage rises. This continues to remain the key to sustainably higher inflation in the long run.
Oddly, Powell said in a throwaway comment that there are concerns with asset prices in some pockets. I’m not sure which market he’s referring to. At current levels I don’t see signs of asset bubbles, I see the S&P 500 and 10-year Treasury yield as fairly valued, and credit spreads as only a little expensive.
Close to normal
In my opinion, the U.S. is close to normal. That’s been the case economically for a while, but with a 2 per cent interest rate, expected to reach 2.5 per cent by year end, monetary policy is also close to normal.
I don’t significantly disagree with the Fed’s outlook for 2018, but Fidelity’s leading economic indicator is suggesting GDP growth won’t stay as strong as it has been, in which case I’m not sure the Fed will be able to deliver the 2019 interest rate increases. I therefore view bonds as attractive at current yield levels. Nevertheless, the yield curve is as flat as it’s been in many years so if the Fed is correct, we will see yields gradually climb higher. My estimate is a terminal U.S. interest of 3.25 per cent, accompanied by a 4 per cent bond yield. I differ from the market in that I think it will take longer to attain those levels.
Whether the U.S. dollar rises depends now on how the European Central Bank (ECB) behaves at its upcoming press conference. If the ECB doesn’t match the Fed’s stance in tightening policy, I expect the dollar to strengthen.
Above-target inflation is a risk, and if wages were to rise more meaningfully, this inflation rise could be big. It’s not my central scenario, though - in fact, I worry more that growth, and ergo inflation, will fade in the months ahead - and as a result, I want inflation protection but don’t want to pay much for it. That’s why I favour an exposure to an emerging market index-linked bond asset class to accompany a balanced portfolio.
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