- FOMC members optimistic on economy; expect inflation to decline further but should be temporary
- We expect the ongoing tightening of the labour market to set the scene for a rate hike in mid-2015
Fed policymakers see a solid US economy…
According to the FOMC statement released today, Fed policymakers are more positive about the US economy. They describe the economy as expanding at a “solid” pace with “strong” gains in employment, upgrading the moderate tone used in the previous statement. They mentioned the positive effects of lower energy prices in household purchasing power. On the other hand, in its assessment to determine how long to maintain the target rate on hold, members added that they will now also focus on international developments. In the previous statement released in December, members downplayed the developments abroad.
…and fall in inflation to be temporary
Inflation is now expected to “decline further in near term”, but the Committee anticipates inflation to rise gradually toward 2% over the medium term as the labour market improves. Headline inflation has fallen sharply as a result of the lower energy prices and core inflation has softened a bit in the past few months. Meanwhile some measures of inflation expectations have declined and the statement added that “inflation compensation measures have declined significantly”. But members appear not to be concerned, since they continue to qualify longer term inflation expectations as “stable”. We think that although core inflation could remain soft in the next couple of months, lower oil prices should add to the positive impetus behind domestic demand, pushing up core inflation eventually.
Fed sticks to ‘patience’ but rate hike in mid 2015 is still likely
Fed members said they would be ‘patient’ in deciding when to raise interest rates, suggesting they would wait at least two meetings. This means a move in June at the earliest. Members had already announced that even if inflation is well below the Fed’s 2% target in the near term, this should not be an impediment to normalising interest rates, as long as core inflation holds up. Indeed the Committee mentioned that “they might begin normalisation at a time when core inflation was at current levels”. We expect the Fed to hike rates in mid 2015 and the federal funds rate to rise to 1.0% at year-end 2015 and to 3% at year-end 2016. This means a hike every other meeting starting in June 2015, after which the Fed steps up the pace to a rate hike every meeting until it reaches 3% at year-end 2016.
Markets ignore Fed’s guidance
Ahead of the FOMC meeting, financial markets had mostly priced out rate hikes for 2015. Investors expected the federal funds rate to be at 0.45% at the end of 2015 and 1.2% at the end of 2016. In fact, regardless of the Fed’s guidance, markets have been pushing rate hike expectations beyond September. This is mainly the result of lower inflation expectations and more monetary easing elsewhere. The adjustment in the statement was not strong enough to change the market view that the Fed will probably hike interest rates only after September. As a result, currency, gold and interest rate markets showed modest movements.