- Fed raises the fed fund target range by 25 bps to 1.25%/1.50% as expected
- The Fed expects the economy to expand at a moderate pace and labor market conditions to remain strong
- Governors expect stronger growth and lower unemployment in 2018/19
- Inflation expectations and the path of expected rate hikes are little changed
- US yields and the dollar cede ground after the Fed’s policy announcement
- US equities stay close to record levels.
Fed 2018/19 rate path unchanged
The FOMC, as expected, raised its Fed funds target range by 25 basis points to 1.25%-1.50%. Two Fed members (Evans and Kashkari) dissented, preferring unchanged rates at this Fed meeting. The run-off of the Fed’s balance sheet will continue as set out in the September policy decision. For now this process develops in the background, as the Fed intended it to be.
The Policy assessment on the economy was little changed from the November statement. The Fed repeated that despite hurricane-related fluctuations, job gains have been solid and that the unemployment rate declined further. Household spending is expanding at a moderate pace. Growth in business fixed investment has picked up in recent quarters. The Fed couldn’t but acknowledge that overall inflation and inflation other than food and energy have declined this year and are running below 2%.
The median forecast of the FOMC showed a mixed picture. Expectations for economic growth were revised higher and the unemployment rate is expected to decline more than previously anticipated. The projections for inflation and the median value for the Fed fund target rate were little changed compared to the September forecast.
Median forecasts for the unemployment rate were revised further downward from 4.1% to 3.9% for 2018 and 2019. The median forecast for growth was revised slightly higher in particular for next year. The median Fed forecast for 2017 was raised to 2.5% (from 2.4%), for 2018 to 2.5% (from 2.1%) and for 2019 to 2.1% (from 2.0%). Fed governors still see the long run growth rate at 1.8%. So, the Fed sees a good chance for the current economic cycle to last a bit longer than anticipated earlier.
Fed chairwoman Yellen said at the press conference that the impact of the tax reform was highly uncertain. She said it could raise aggregate demand and have a (moderately?) positive impact on supply. However the Fed chair also aired some concerns on rising debt levels. On financial stability, she said she didn’t see a worrisome build-up in credit or leverage. Noting is flashing red or orange on financial stability.
Yellen gave an ‘interpretation’ on the recent flattening of the yield curve. The Fed Chair doesn’t see this flattening of the curve as a precursor of a recession. In the past, an inverted yield curve was the result of short-term rates rising well above average expected rates over the longer term, meaning that monetary policy had become restrictive. This is currently not the case. This time, the flattening of the yield curve is due to the time premium of LT yields to remain stubbornly negative as investors don’t see any upcoming risks that would push yields higher.
Changes in the median inflation forecast and the forecast of the expected rate path were less pronounced than for growth and, to a lesser extent, unemployment. The expected path for the (core) PCE deflators was unchanged from September with inflation expected to rise to 1.9% in 2018 and to 2% in 2019 and 2020.
Despite a divergent picture on activity indictors on the one hand and price indicators on the other hand, the Fed governors basically left expectations for the Fed rate path unchanged. The median forecast for the Fed fund rate target still stands at three rate hikes in 2018 and two rate hikes in 2019. The median forecast for 2020 was slightly upwardly revised, indicating at least one additional rate hike in 2020 (median 3.1%) bringing the Fed rate at time well above the LT equilibrium rate (2.75%).
Conclusion: the Fed expects the economic recovery to stay well on course in 2018 and to decelerate more slowly in 2019. Even at that time growth remains above the LT trend. At the same time inflation remains modest, but the Fed still maintains the view that mainly transitory factors are holding inflation low. Over time, growth and a further decline in unemployment will contribute to inflation returning to target
Markets react soft to Fed decision
The market reaction to the Fed rate decision and the new Fed forecasts was modest. On bond markets, the repositioning that started after the publication of the November CPI data, yesterday afternoon, continued. US government bond yields declined another 4 to 5 bps with the belly of the curve slightly outperforming. The implied market probability of a March Fed rate hike declined from about 65% to 56%.
The loss of interest rate support weighed on the dollar. EUR/USD rebounded further from the 1.1775 area to close the session at 1.1826. USD/JPY broke below the 113 handle. US equities tried to extend gains immediately after the Fed decision. The S&P almost exactly touched the intraday record peak, but a sustained new upleg/break failed. US indices closed the session little changed (S&P) to modestly higher (Dow and Nasdaq).
