Monetary policy doves make a surprise appearance

The Federal Open Market Committee (FOMC) left interest rates unchanged at Wednesday's meeting, as expected; however, the dovish tone came as a surprise to some.

The FOMC released a whole host of new data for us econodorks to pour over on Wednesday afternoon, alongside the decision to keep rates where they are. The biggest news was the revised dot plot, suggesting that the Fed only expects two rate hikes this year, with little catch-up in subsequent years (the neutral federal funds rate fell 25 bps, to 3.25%).¹ This rubbed a lot of economists the wrong way, given that employment and inflation data has improved since the last dot plot was released in December. The FOMC is now in line with our own forecast for two rate hikes in 2016.

The U.S. Federal Reserve (Fed) also released a series of new GDP, inflation, and unemployment forecasts. The FOMC revised its GDP growth projections down moderately, from 2.4% to 2.2% in 2016 and 2.2% to 2.1% in 2017. Core PCE (personal consumption expenditure)—the Fed's favorite measure of inflation—was left unchanged at 1.6% in 2016, even though core PCE had picked up to 1.7% in January.² This suggests that the FOMC is skeptical that inflationary pressures will be sustained. This is wise—one-off spending measures in healthcare, which will continue to drop out of the year-over-year comparisons, have been a key cause of the recent higher core PCE readings. We do not expect core PCE to continue to tick upward in the second half of this year.

Unemployment was revised down slightly, to 4.6% in 2017 and 4.5% in 2018.¹ The forecast for long-run non-accelerating inflation rate of unemployment was also revised lower, from 4.9% in December to 4.8%.¹ That the Fed revised both its growth and unemployment projections downward suggests that the FOMC has also downgraded its forecast for productivity growth or the participation rate—or both. That is not a great sign for the U.S. economy. In the press conference, Fed Chair Janet Yellen surprised markets with her dovish rhetoric, which highlighted that the stability of longer-term inflation expectations cannot be taken for granted. In terms of the labor market, she noted improvements but said that slack remains, as evidenced by a lack of sustained wage growth and still high numbers of involuntary part-time workers.³

Chair Yellen also highlighted concerns about the international environment, citing the slight downgrade in global growth projections by the International Monetary Fund.⁴ However, the international environment from a macroeconomic perspective looks slightly less scary now than it did in December, thanks in part to central bank easing in Japan and the eurozone. It seems that the Fed remains slightly spooked by the market volatility that we saw in the first two months of 2016.

Off the back of the FOMC statement, the U.S. dollar fell by 1.2%.⁵ We're sure this was not the primary intention, but a weaker dollar will be embraced by U.S. businesses.We expect the next rate hike to be announced in June, with a second rate hike toward the end of the year. That being said, the risks to this forecast are on the downside, and it is more likely that we will get only one rate hike, rather than three, in 2016. It appears the Fed has undershot its inflation target for so long that the central bank is willing to accept some temporary inflation overshoot to achieve an average of 2.0% over the medium term. While we think inflationary pressures will remain elusive, if they do come in, the Fed will most likely tolerate them rather than risk hiking rates too quickly in order to squelch them.

1 “Economic Projections,” U.S. Federal Reserve, as of 3/16/16.
2 “Personal income and outlays: January 2016,” Bureau of Economic Analysis, as of 2/26/16.
3 U.S. Federal Reserve,transcript of Chair Yellen's press conference opening remarks, as of 3/16/16.
4 “World Economic Outlook Update: Subdued Demand, Diminished Prospects,” IMF, as of January 2016.
5 Bloomberg, as of 3/16/16.