- The Fed continued to reduce its QE-programmes and moved to a more qualitative forward guidance
- It dropped the 6.5% unemployment rate threshold, while signalling earlier rate hikes
- The dollar and US rate expectations move higher
Fed continues to taper…
The Fed continued to reduce its asset purchase programmes by $10bn during its meeting. It will cut its monthly MBS purchases by $5bn to $25bn a month, while reducing its Treasury purchases to $30bn down from $35bn a month. Although growth in economic activity had ‘slowed’ during the winter months, in part reflecting adverse weather, the Committee judged that there was ‘sufficient underlying strength’ in the broader economy to support ‘ongoing improvement’ in labour market conditions. Indeed, although in its Summary of Economic Projections, the FOMC modestly scaled down its growth forecasts for 2014 (from a midpoint of 3.0% to 2.9%) and for 2015 (from a midpoint of 3.2% to 3.1%), it sees a stronger labour market recovery with the unemployment rate falling to 6.2% in the fourth quarter of this year. In contrast, in its December projections, the FOMC saw an unemployment rate of 6.5% in 2014Q4. Meanwhile, for 2015Q4, the midpoint unemployment rate forecast was lowered from 6.0% to 5.8%, though inflation forecasts for 2014 and 2015 were broadly unchanged.
…while moving to a qualitative forward guidance…
With the unemployment rate soon breaching the 6.5% threshold that the FOMC originally had signaled would trigger rate hikes, the Fed decided to alter its forward guidance, paying less attention to the unemployment rate. Indeed, in her press conference, Chair Yellen said that in assessing labour market slack to determine deflationary measures, one needed to look at other measures of labour market conditions as well. Moreover, in determining how long it will keep rates on hold, the FOMC will also assess indications of inflation pressures, inflation expectations, and readings on financial developments.
…and expecting more rate hikes
Although the FOMC continued to signal that rate hikes are still far off – with the statement mentioning that rates would remain lower than what normally would be the case, even as inflation and employment were to return to longer-run levels, the stronger projected labour market recovery prompted Committee members to raise the likely path of interest rate hikes. Indeed, the median level of the federal funds rate for the end of 2015 was now seen at 1%, instead of 0.75% previously, while the median appropriate level of the federal funds rate for 2016 was now estimated to be 2.25%, rather than 1.75%. Still, given our forecasts for inflation and the unemployment rate, we expect the Fed to start raising rates a bit earlier. This reflects that we continue to see a stronger recovery than the Fed, with the unemployment rate set to fall more sharply. As such, we see the first rate hike in the middle of 2015, with the Fed raising the federal funds rate to 1.5% at the end of next year, which is a somewhat higher pace of rate hikes than the Fed is currently communicating.
The dollar and US rate expectations move higher
Ahead of the FOMC decision, currency markets moved sideways, but the 10-Y US Treasury yield rose while gold prices moved lower. This behaviour could also be a reflection of an overall improvement in investor sentiment. The market appears to be less concerned about the possibility of a further escalation of the tensions between Ukraine and Russia. The improvement in risk appetite has shifted the focus from safe-haven assets to higher yielding ones. The FOMC statement caused some confusion in the market. Initially, the US dollar fell under pressure, but afterwards it recovered strongly mainly because of the Fed’s higher likely path of interest rate hikes. USD/JPY rallied above 102.50 while EUR/USD dropped below 1.3850. Moreover, interest rates moved higher, not only interest rate expectations for 2015 (see graph), but 10-Y US Treasury yield rose as well. In contrast, gold prices fell under more pressure and US equities moved lower as well.