Making sense of the March US Federal Reserve rate-setting meeting
Sanisha Packirisamy, Economist at MMI Holdings.
Herman van Papendorp, Head of Asset Allocation at Momentum.
In line with the consensus expectation (see chart 1) the US Federal Reserve (Fed) left interest rates on hold at the March rate-setting meeting at the effective rate of 0.36%.
Measured approach to future rate hikes as US Federal Reserve balances conflicting economic outcomes
The Fed continues to face conflicting signals in the real economy. While labour market data paints a robust employment picture in the US, growth momentum has slowed. Furthermore, despite headline rates of unemployment dropping close to the assumed natural rate, inflation has failed to pick up meaningfully, creating further confusion over the extent of remaining slack in the US economy.
Chart 1: Market probability of a rate rise fizzled out to below 5% in the run up to the March meeting
Source: Bloomberg, Momentum Investments
Economic data surprises in the US bottomed out in early February subsequent to weaker-than-expected manufacturing sentiment, factory orders and retail sales. Growth estimates for the first quarter of the year have been scaled back by a considerable 0.7% over the course of the past year to the current 2.2%. This is still marginally higher than the Atlanta Fed GDP Nowcast, which pitches real growth in GDP over the first quarter of 2016 at 1.9%, taking account of the most recent economic activity. The recent reversal in the extent of negative surprises (see chart 2) could likely be attributed to rising employment growth and moderately increasing wages, while recent dollar movements could limit the drag on net exports and could leave overall growth close to trend (which we see at 2%) this year.
Chart 2: Negative economic surprises peaked in early February
Source: Bloomberg, Momentum Investments
A paper produced by the Fed in June last year argued that weaker labour bargaining power and a lower labour share of output (see chart 3) have been the main culprits for the slow uptick in inflation and, as such, the economy could continue adding jobs without inducing significant upward pressure to wage inflation. In the Q&A session, Fed Chair Yellen alluded to inequality, technological changes and globalisation driving downward pressure on wages in select groups.
Chart 3: Shrinking labour share of US economy has likely eroded labour bargaining power
Source: Deutsche Bank, Momentum Investments, shaded area = recessions
Subdued international oil prices have been a major negative contributor to headline inflation in the US (see chart 4). Even if oil prices remain around their current levels, Capital Economics expects energy inflation to rise from its current negative rate to zero during 2017.
Chart 4: Contribution of energy to headline inflation (%)
Source: Capital Economics
US headline inflation has also been suppressed by dollar appreciation, but the dollar has more recently weakened by over 3% on a trade-weighted basis between December 2015 and March 2016 (to date), suggesting upward momentum in core prices. Core or underlying inflation (i.e. headline inflation excluding the prices of food and energy) reached 2.2% in January this year, partly owing to a statistically low base created by a once-off drop in medical care costs in January last year, but is nonetheless set to rise further on the back of reasonably firm demand and a steady rise in wage growth (see chart 5).
Chart 5: Average measure of wage inflation has increased from 1.3% in January 2014 to 2.4% more recently
Source: Bloomberg, Momentum Investments
The CBOE VIX volatility index has retraced from 27 to below 17 since the last Fed meeting. The part-reversal in negative economic surprises further suggests that uncertainty has abated somewhat. Nevertheless, the Federal Open Market Committee (FOMC) members are likely to remain wary of the potential implications of global economic and financial conditions on the US labour market and inflation metrics and as a result are expected to maintain a cautious approach to subsequent rate hikes.
Some members of the FOMC have also been warning about the tightening in financial conditions which could warrant a further delay in rate hikes. The financial conditions index (FCI), which includes variables such as the US dollar, the equity market and credit spreads, has tightened significantly since 3Q14 (see chart 6). Goldman Sachs suggests that the extent of tightening in the FCI equated to a 0.8% drag on GDP growth in the final quarter of 2015.
Chart 6: Tighter financial conditions has a contractionary effect on growth
Source: Bloomberg, Momentum Investments
That being said, consumption- and services-based economic indicators remain reasonably firm. The ISM non-manufacturing index printed above 53 points in the latest February reading, while the University of Michigan Consumer Sentiment Index is currently trading at 6 points higher than the longer-term average. In the Q&A statement, Fed Chair Yellen addressed this issue, suggesting that consumer gauges, ranging from sentiment to the labour market were in “solid” territory.
Moreover, the Fed still expects inflation to rise to 2% over the medium term given their view on currently-low import and energy prices being transitory in nature. Survey-based inflation expectations have remained steady with the one- and two-year projections remaining marginally above the Fed’s 2% target. The current year figures further incorporate the low oil price base created over 2015 which should benefit inflation this year (see chart 7). The expectation of a rising inflation profile and a moderate expansion in growth likely still supports the view for two interest rate increases of 25 basis points each over the course of 2016, in line with the Fed’s downwardly-revised median expectation.
Chart 7: Longer-dated inflation expectations remain above Fed’s 2% target
Source: Bloomberg, Momentum Investments
Global outlook still concerns the Fed
The tone of the Fed statement suggested a more cautious assessment of economic conditions. The Fed continued to warn against global economic and financial developments, but revealed a more constructive take on domestic developments, citing a moderate expansion in activity, an uptick in inflation and additional strengthening in the US labour market. Although one member dissented in favour of a rate increase, interest rate expectations have been scaled back, with most members advocating only two interest rate increases this year.
In their quarterly economic projections, the Fed revised down growth, most likely on the back of weaker-than-anticipated net exports and softer fixed investment. They now see real GDP growth increasing by 2.2% this year from a prior estimate of 2.4%, just marginally above their trend growth projection of 2% (see chart 8). Further improvements in the labour market have lowered the Fed’s expectation on headline unemployment in 2017 and 2018, while they downwardly revised their assumption on the natural rate of unemployment to 4.8% from 4.9% previously (see chart 9).
Chart 8: Fed’s real GDP growth projections (%) deteriorated for 2016, but remained steady at 2.0% in the longer term
Source: Federal Reserve, Momentum Investments, dot = mid-point of central range
Chart 9: Improvement in Fed’s shorter- and longer-term unemployment projections (%)
Source: Federal Reserve, Momentum Investments, dot = mid-point of central range
Although the Fed did not address the balance of risks to the inflation outlook, the Q&A session addressed the resilience of the US economy and the recent pick up in oil prices. These statements were balanced by comments that high inflation readings are showing up in categories that tend to be “quite volatile”, leaving the committee wary on concluding that inflation is trending up.
Chart 10: Transitory factors affecting 2016 PCE inflation outlook (%)
Source: Federal Reserve, Momentum Investments, dot = mid-point of central range
Chart 11: Slightly lower core PCE inflation outcome anticipated in 2017, but Fed expects core PCE to reach 2.0% by 2018
Source: Federal Reserve, Momentum Investments, dot = mid-point of central range
The cautious tone of the statement was echoed in the further move lower in the median dot plot of the FOMC members’ rate hike expectations (see chart 12 and 13), edging ever closer to the more sanguine view of the market. The median Fed expectation for the equilibrium interest rate (the rate ultimately consistent with stable growth) was revised lower to 3.25% from 3.5% previously, which may still be too high given that potential growth is likely to be closer to 2% than the c.3% rates observed historically. The statement stressed that future interest rate decisions will continue to be shaped by the evolution of the economic data. If inflation remains low and/or global economic and financial developments deteriorate, policymakers would likely proceed more cautiously with rate increases, resulting in the federal funds rate peaking at a lower neutral rate. Yellen confirmed this point in the Q&A session, intimating that the Fed would stay on the sidelines in the event that the US labour market and growth overall did not continue to strengthen on the back of escalating risks abroad. She further reiterated that the pace in rate tightening would be “gradual”.
Chart 12: Fed members’ indicate a lower profile for interest rates
Source: Federal Reserve, Momentum Investments
Chart 13: Fed dot-plot shifting lower and moving closer to market expectations
Source: Bloomberg
A more gradual approach to raising rates
The tone of the statement and continued concerns over the impact of global economic and financial developments on the US economy confirms a gradual approach to interest rate normalization. However, constructive comments on consumer drivers in the US and still-intact longer-dated inflation expectations by the Fed suggests that we cannot rule out the possibility of two interest rate increases this year. The Q&A session also quashed speculation of negative interest rate policy in the US. Yellen admitted that negative rates were not something that the Fed was actively considering and even though there were “more connections and spillovers between nations on the financial front”, US rate policy was “not constrained by the actions of other nations”.
Though interest rate expectations have moderated in the US, ultimately higher interest rate prospects in the US should see capital flows accelerate away from emerging markets (EM), exacerbating funding concerns for those economies heavily reliant on foreign flows to fund fiscal and current account deficits. Apart from being exposed to potentially tighter financial conditions as a modest Fed hiking cycle gets underway, net commodity-exporting regions, including South Africa, are facing the headwinds of a less commodity-dependent Chinese growth model.
Moreover, elevated borrowing across EM poses an additional threat to global GDP prospects. According to the Bank of International Settlements, EM borrowing has doubled in the recent five-year period as EM corporations ramped up debt levels when the cost of borrowing was more favourable. Any local currency devaluation triggered by a reversal in capital flows could worsen the debt burden faced by key EMs going forward.
Table 1: Shift in key variables between the latest Fed meetings
Language shift in the statements between the January 2016 and March 2016 meetings
