FOMC – Yellen warming up the engines. The March meeting resulted, as expected, in a 10 billion dollar tapering of asset purchases, and in a change in forward guidance in more qualitative terms. The statement, and the projections of…
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macroeconomic variables and policy rates, brought a few surprises, some of which less dovish than in the December statement. The message is that the FOMC will be patient before starting to hike rates (probably in mid-2015), and the interest rate path will probably keep fed funds below the levels viewed as “normal in the longer run” for “some time”. The key issue, by now, is not so much “when” rates will rise, but “by how much” they will rise after mid-2015. Rates will be somewhat higher than expected by the market until before the meeting, but still well below the levels indicated by past experiences or by a Taylor rule. Our forecast is for higher rates than implied by fed funds futures: between 1 and 1.25% at end 2015, between 2.5 and 3% at end-2016 and at 3.5% at end-2017.
– Let’s start with the assessment of the economy. As expected, the Fed says that economic activity slowed in recent months “in part reflecting adverse weather conditions”. In any case, despite the negative surprises and the volatility of the indicators, the Committee continues to see signals of an improvement in labour market conditions, and of growing consumption and investments, as opposed to a still weak residential construction sector, and to the fact that public spending is holding back growth, although it should not do so for much longer. As regards prices, the assessment remains the same: inflation remains below target, but expectations are anchored. The FOMC’s conclusion is that risks to the economy and to the labour market are now “nearly balanced” (in January, the assessment was that risks were “more nearly balanced”). Also, the economy is now considered to have sufficient “underlying strength” to support on-going improvement in labour market conditions. These two considerations are important to pave the way towards the exit.
– No changes compared to December on the tapering front: the scenario is in line with fed projections, and allows asset purchases to be reduced at a “measured” pace, even though the process is not automatic, and remains dependent on the evolution of economic data.
– As achievement of the 6.5% unemployment rate threshold nears, the Committee has changed forward guidance, making it qualitative, while stressing that this does not imply a change in its “policy intentions”. The new formulation of guidance touches on two aspects:
1) when rates will start rising; and 2) how rapidly they will be raised. As regards the former point, the statement says that a highly accommodative stance remains “appropriate”; in order to determine for “how long” to maintain the fed funds rate’s current level, “the Committee will assess progress – both realised and expected – toward its objectives of maximum employment and 2% inflation”. The assessment will be guided by the analysis of “a wide range of information”, including measures of labour market conditions, and indicators of inflation pressures, as also declared in previous statements. As regards point 2), which represents another new element in the statement, “when the Committee decides to begin to remove accommodation, it will take a balanced approach” consistent with its two goals; also, the Committee expects that even once long-term goals are reached (i.e.: end-2016), economic conditions may, “for some time”, warrant keeping the fed funds rate “below levels the Committee views as normal in the long run” (i.e.: 4%). This is the core of the message sent by the March meeting.
– As regards projections, some of the changes were expected. The upper limit of the growth range has been lowered by 2 tenths at the end of each year on the forecasting horizon (2014-16). Growth is forecast between 2.8 and 3% at the end of 2014 (from 3-3.2% in December). The projected unemployment rate has been revised to 6.1-6.3% from 6.3-6.6% at the end of 2014, and the estimated range for long-term unemployment (5.2-5.6%) would be reached at the end of 2016. No significant changes were made to inflation forecasts. The estimated long-term unemployment is now marginally lower (5.2-5.6%, from 5.2-5.8%), and potential growth is only slightly lower than in December (at 2.2-2.3% from 2.2-2.4%).
– Interest rate projections have risen marginally; a wide majority of participants (13 out of 16) continue to expect an initial hike in 2015, but now the majority (11) forecasts a fed funds rate of at least 1% at the end of 2015 (from 0.75% in December), and 12 out of 16 participants expect a fed fund rate of 2% or higher at the end of 2016 (also 25 bp higher than in December). This signal was read by the market as an indication of higher rates than expected, once the rate hiking cycle begins, and has led to a bear flattening of the yield curve, together with an appreciation of the dollar against all the other currencies.
– During her press conference, Yellen warned against affording too much importance to marginal changes in projections, stressing that the message on which the market should focus is one of the new elements contained in the statement, i.e. the explicit reference to the fact that the Committee believes rates will stay below the levels viewed as normal in the longer run “for some time” after achievement of full employment, especially if inflation stays below the 2% target at length. In fact, Yellen emphasised that the longer inflation stays below target, the longer the period characterised by rates below their “normal” levels could be. In response to a call to quantify the “considerable” time expected to pass between the end of the purchase programme and the first interest rate hike, Yellen, with a little hesitation (and possibly a few later regrets for having quantified the adjective “considerable”) said that this could be something “around six months”. This statement implies a forecast by Yellen, if not by the majority of FOMC participants, that the first rate hike could be implemented around 2Q 2015, given that according to Yellen the asset purchase programme should be terminated around autumn this year. In her press conference, Yellen also touched on a discussion concerning the variables that the FOMC will monitor to assess the progress of the labour market, without adding relevant details to those already provided in previous speeches.
– Yellen’s communication was effective and transparent on the whole, consistently highlighting the opinions of the Committee in its entirety as well as of its individual participants, rather than her personal view: as expected, Yellen’s leadership has a markedly collegial style. Her task will not be easy one, as she will have to guide market expectations along a path preparing them for the hike cycle phase. For the time being, rather than take stock of the reassuring words offered, the market has opted (we think correctly) to focus on the FOMC’s interest rate projection charts. An adjustment in expectations for somewhat steeper rises was probably due, given the current outlook. Still, the market in our opinion remains exceedingly cautious. Our forecast is for higher rates throughout the horizon 2015-16, around 1% by end-2015, 2,75% at end-2016 and 3.5% at end-2017. Our argument in favour of a faster hiking speed in 2016 is based on a forecast of lower unemployment, faster wage growth with respect to the Fed’s projections.
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