FOMC Decision, by Tim Duy: If you were looking for fireworks from today's FOMC statement, you were disappointed. Indeed, you need to work pretty hard to pull a story out of this statement. It provided little reason to believe that the Fed has shifted its view since December. A June rate hike remains the base case.
The Fed's assessment of the current statement is arguably the best in years:
Information received since the Federal Open Market Committee met in December suggests that economic activity has been expanding at a solid pace. Labor market conditions have improved further, with strong job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources continues to diminish. Household spending is rising moderately; recent declines in energy prices have boosted household purchasing power. Business fixed investment is advancing, while the recovery in the housing sector remains slow.
The Fed is simply not seeing any warning signs in recent data. Regarding inflation:
Inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices. Market-based measures of inflation compensation have declined substantially in recent months; survey-based measures of longer-term inflation expectations have remained stable.
They continue to dismiss headline inflation, and I think they will continue to do so. And if you continue to insist that the Fed is paralyzed with fear over market based measures of inflation expectations, note that they do not refer to these as "expectations" measures. It is inflation "compensation." From Fed Chair Janet Yellen's most recent press conference:
There are a number of different factors that are bearing on the path of market interest rates, I think, including global economic developments. It is often the case that when oil prices move down and the dollar appreciates, that that tends to put downward pressure on inflation compensation and on longer-term rates. We also have safe-haven flows that may be affecting longer-term Treasury yields. So I can’t tell you exactly what is driving market developments. But what I can say is that we are trying to communicate our thoughts as clearly as we can.
Oh, and longer-dated expectations. Well, what I would say, we refer to this in the statement as “inflation compensation” rather than “inflation expectations.” The gap between the nominal yields on 10-year Treasuries, for example, and TIPS have declined—that’s inflation compensation. And five-year, five-year-forwards, as you’ve said, have also declined. That could reflect a change in inflation expectations, but it could also reflect changes in assessment of inflation risks. The risk premium that’s necessary to compensate for inflation, that might especially have fallen if the probabilities attached to very high inflation have come down. And it can also reflect liquidity effects in markets. And, for example, it’s sometimes the case that— when there is a flight to safety, that flight tends to be concentrated in nominal Treasuries and could also serve to compress that spread. So I think the jury is out about exactly how to interpret that downward move in inflation compensation. And we indicated that we are monitoring inflation developments carefully.
They are trying to tell us very clearly that TIPS are not giving a measure of pure inflation expectations. They do not want those measures by themselves to affect market expectations of the path of monetary policy.
Growth risks are balances and low inflation is transitory:
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to decline further in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate. The Committee continues to monitor inflation developments closely.
They make a small nod to international concerns when considering future policy actions:
This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.
The Fed remains patient and policy is data dependent:
Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.
June remains on the table. Within the context of the current forecast, I think that June will be difficult to justify in the absence of wage acceleration. A sharp decline in the forecast, or the balance of risks to the forecast, would also prompt a delay. Importantly, at this point they see the current forecast as still the most likely outcome.
Bottom Line: At this point, the Fed does not see market turbulence as an impediment to raising rates. They are willing to hike rates even if stocks are moving sideways (which they probably think is reasonable in the context of expectations for less monetary accommodation). They do not see any data that threatens their baseline forecast. Maybe market participants have written off June, but for the Fed, June remains very much on the table.