- FOMC minutes shows divisions on communication and timing of hikes, but mood generally cautious
- We continue to expect a rate hike in June, though risks are tilted towards somewhat later move
- US dollar rally has stalled for now, but we expect a restart soon supported by fundamentals
FOMC members divided about dropping “patient”…
The minutes of the January FOMC meeting revealed that Fed policymakers are facing communication challenges associated with signaling policy normalization. Many participants regarded dropping the term “patient” in the statement as “risking a too rapid shift in market expectations that might result in undesirably tight financial market conditions”. There were also differences among members in defining the economic conditions that are necessary for a rate hike, which makes the underpinning of an adequate communication strategy more difficult. Indeed, members are divided in the assessment of the risks in maintaining interest rates at the lower bound too long and raising rates too rapidly. The decision, therefore, remains essentially data dependent.
…and about rate hike in a low inflation environment
The minutes show concern among some members about commencing tightening at a time when inflation is running below 2%. January’s FOMC statement was more firm regarding the future inflation path. The statement mentioned that inflation should continue to decline in the “near term” but will resume towards the Fed’s 2% goal over the medium term as the labour market improves and the transitory effects of lower energy prices dissipate. Now the minutes suggest that some participants would like to see a stable or rising levels of core PCE inflation, or alternative series, to restore their confidence that underlying inflation will return to the 2% target. In general, since the last FOMC meeting, core inflation measures have softened a bit, but long term measures of inflation are more stable.
A more cautious Fed than expected
Despite the positive tone of January’s statement on the US economy, a number of developments, including the recent steps taken by central banks to ease policies, the effects of a stronger dollar and lower inflation have made Fed officials more cautious in their deliberations. We think that the economic outlook will strengthen offering more positive data in the coming months which should lead to a rate hike in mid-June. However, the FOMC minutes do underline our sense that the risks to our central scenario are tilted towards a somewhat later rate increase.
US dollar rally stalled for now…
The US dollar Index rose by around 17% in the period July 2014 to mid-January 2015. Since then the rally has lost momentum. This is rather surprising because the ECB and other major central banks eased monetary policy further and the strong US employment report has pushed US yields higher. So why has the US dollar not strengthened further? For starters, sentiment towards the eurozone has improved. This has been driven by stronger than expected eurozone economic data and optimism that Greece and the eurozone will eventually come to an agreement. Moreover, there has been doubt about the Bank of Japan’s stance about a further weakening of the yen. Last but not least, US economic data –apart from US employment report – have been somewhat weaker. Financial markets continue to be reluctant to price in the rate hikes that the US Fed is currently signaling will occur at some point this year.
…but we expect a resumption soon
The recent loss of momentum in the US dollar rally is just a pause in our view. First, US assets remain very attractive, because of superior economic growth and interest rates. Second, the current account balance has moved to sustainable levels. Third, the fiscal deficit has declined sharply. Fourth, US political environment is relatively stable compared to the heavy political calendar in the eurozone this year and next year. Last but not least, the uptrend in the US dollar has just started and the traded-weighted index remains relatively low.