As expected, last week’s US Federal Reserve’s March meeting statement dropped the reference to the Fed being ‘patient’ in regard to increasing interest rates writes John Fahey, Senior Economist at AIB.

Fed Keeps Its Options Open On Interest Rate Increases

Fed Keeps Its Options Open On Interest Rate Increases

As expected, last week’s US Federal Reserve’s March meeting statement dropped the reference to the Fed being ‘patient’ in regard to increasing interest rates writes John Fahey, Senior Economist at AIB.

 

The Fed anticipates that it will be appropriate to raise interest rates “when it has seen further improvement in the labour market and is reasonably confident that inflation will move back to its 2% objective over the medium term”.

While the removal of the word ‘patient’ was important, there was no clear indication from the statement or the press conference that the Fed has decided on the timeframe for such tightening. Instead, chair Janet Yellen stated that an increase in April was unlikely, but “such an increase could be warranted at any later meeting depending on how the economy evolves”.

 

In other words, any tightening of monetary policy is data-dependent and therefore the Fed is in data-watching mode.

 

In this regard, the Fed has become more cautious in its views on the economic outlook. In recent weeks, the macro data (with the exception of labour market figures) have tended to be on the soft side. This has included weaker than expected retail sales for January/February, housing market indicators, industrial production, and a raft of survey data.

 

The Fed’s concerns are evident in the downgrading of its growth and inflation forecasts. GDP growth for 2015 is now projected at 2.5% (from 2.8%), with growth for 2016 also revised down to 2.5%. Meanwhile, core inflation projections for 2015 and 2016 were lowered to 1.35% and 1.7%, respectively.

 

The weaker outlook for net exports was cited (related, in part, to the stronger dollar) as a key reason for reducing its growth forecasts. Meanwhile, the lower inflation projections were mainly due to lower energy and import prices (which, in turn, is also linked to the appreciation of the dollar).

 

Reflecting these new growth and inflation forecasts, the Fed’s monetary policy committee members’ projections on the likely path of interest rates were also lowered. The median projection for the end of 2015 was lowered to 0.625% (from 1.125%) and for the end of 2016 to 1.875% (from 2.50%).

 

Despite these lower projections, there is still a gap between where the market expects rates to go in the next couple of years and the assessment of the Fed on the likely path of interest rates. Financial markets are looking for rates to rise to around 0.5% by the end of 2015 and 1.25% by the end of 2016 from 0.125% at present.

 

The markets believe very subdued inflationary pressures will give the Fed the scope to maintain a very accommodative monetary policy, even after it begins to hike rates. For its part, the Fed has consistently said when it begins to raise rates, it anticipates it will be at a moderate pace.

 

Overall, the latest updates from the Fed have been less hawkish than expected. This was reflected in market reaction to the meeting with stocks and bond prices rallying. Meanwhile, on the currency front, the dollar weakened as the markets viewed the cautious tone from the Fed on the economy as a sign it will be slow to tighten interest rates.

 

We expect Fed rate hikes to materialise later this year, as falling energy prices will provide a significant fillip to consumer spending helping to underpin growth, the labour market tightens further, and wage inflation starts to pick up. Much of the recent slowdown in activity is weather-related, so the economy should regain momentum as the weather improves.

 

However, with less clarity on the future direction of monetary policy, markets are likely to prove more volatile. We could see a much greater reaction to US economic figures with monetary policy now, clearly, very data-dependent as the Fed keeps its options open.

 

Source: Irish Examiner March 24th 2015

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