As expected the Fed held rates unchanged, but in a dovish twist is now predicting only two rate hikes in 2016 vs four back in December according to the median of the dot plots. For 2017, the Fed is still looking for four rate hikes thus taking the path down 50 basis points compared to the December projections. Maybe as a consequence of weak productivity growth, the Fed’s view of the long-term equilibrium funds rate was also taken down a notch to 3.3 percent compared to 3.5 percent in December. In any event, there still is a huge gap between the Fed and market expectations that must close. Moreover, don’t forget that the Fed is data-dependent and given that the labor market is already operating at the NAIRU and core inflation rising fast already, monetary policy may well still be normalized more aggressively than suggested today.
Elsewhere the forecast changes were pretty small; real GDP growth is seen a tad lower this year and the next, while the outlook for core PCE inflation is unchanged for 2016 and a tenth lower in 2017. That was admittedly a surprise given that inflation already is sitting at the Fed’s year-end forecast and is trending up. What is at play here is a more favorable NAIRU outlook; not only is the Fed seeing the unemployment rate declining slightly in the years ahead but longer run unemployment view was also revised a tenth lower. The Fed is now seeing unemployment rate reaching a bottom at 4.5 percent in 2018. Indeed, the rock-steady unemployment rate forecast back in December was looking strange. What is more peculiar now is that nobody expects inflation above 2 percent at any point over the next three years. Go figure.
Following January’s example, the Fed gave no balance of risk assessment today. This is one of the keys since had the Fed, by contrast, suggested that risks were “nearly balanced” it would have been an indication that the next hike was in the pipeline and could even have put the April meeting on the map. Evidently, that was not a risk the Fed was willing to take, the better domestic growth outlook notwithstanding. The Fed is indeed feeling better about the growth outlook thus suggesting that economic activity has been expanding at a moderate pace despite recent global and financial developments. What is currently holding the Fed back is instead the global outlook which continues to pose risks according to the Fed.
So the bottom line is that while going into the meeting we saw risks that the Fed would sound hawkish at the margin, the upshot is that we are now relatively comfortable with our two hikes in 2016 baseline. As such, our forecast is still for hikes in September and December, respectively. In any event, the probability of hikes in the first half of the year is definitely lower now compared to when going into the meeting and the June rate hike odds moved back below 50 percent.
As expected, Kansas City Fed president George voted against the majority, instead wanting to hike rates today already. If she is the one who believes that the NAIRU actually is 5.8 percent, we totally understand why she wants to hike rates at the current juncture.
At the press conference, while acknowledging that recent inflation readings have been on the high side Chair Yellen was not sounding convinced that the uptick in core inflation was for real. However, looking beyond the monthly gyrations, if history is any guide what usually happens late-cycle is inflation turning higher. Furthermore, she acknowledged that growth appears to have picked up and said that the Fed was still looking for above-trend growth.
With respect to wage growth, Yellen was surprised that it had not picked up more already. While the next round of average hourly earnings may well be soft too due to calendar effects, we say come the summer AHE will really pick up.
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