Allan von Mehren
Danske Bank A/S
In the statement today the Fed made a change in a more hawkish direction by changing the language on both the labour market and inflation in a slightly more positive direction. Also, Fed member Charles Plosser (hawk) dissented to the forward guidance phrase on the timing of the first rate hike.
As Fed chairman Janet Yellen indicated at the semi-annual testimony the Fed is moving faster towards its targets than expected and the risk is that Fed hikes come earlier and less gradually than what is in the current Fed projections.
On the labour market there were a couple of changes: a) in the description the statement now says “Labor market conditions improved, with the unemployment rate declining further. However, a range of labor market indicators suggests that there remains significant underutilization of labor resources.” This is a change from “Labor market indicators generally showed further improvement. The unemployment rate, though lower, remains elevated”. Hence, the Fed no longer says the unemployment rate is elevated but instead it highlights that there is still plenty of slack, so this tones down the hawkish twist a bit. In the forward-looking part the Fed now says that it expects labour market indicators move towards a level consistent with its dual mandate. Before it said that labor market conditions will “continue to improve gradually”. The word “gradually” is now skipped, a further sign that the labour market is improving faster than the Fed has expected.
Similarly on inflation the language has changed: the Fed is no longer concerned about the risks from persistently low inflation. In the first paragraph (the description) the Fed now says “Inflation has moved somewhat closer to the Committee's longer-run objective. Longer-term inflation expectations have remained stable” instead of “Inflation has been running below the Committee's longer-run objective, but longer-term inflation expectations have remained stable”. In the second paragraph (the forward-looking part) the Fed is now saying that inflation is expected to move towards the target and “judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat.” This stands in contrast to the previous phrase that “The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term”.
Finally, Charles Plosser dissented objecting to the forward guidance that “it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends.” “because such language is time dependent and does not reflect the considerable economic progress that has been made toward the Committee's goals. ”
All in all, this was a more hawkish statement than last time and we still believe the market is too complacent about the future Fed path as the first hike is still priced in Q3 15 and the market is priced 65bp below the Fed’s own projection at the end of 2016 (1.85% versus Fed’s median projection of 2.5%).
Given the change in rhetoric, we now expect the Fed to hike rates in April 2015 rather than mid-2015. As unemployment continues to fall and inflation increases we believe the rise in short end yields is likely to continue as the market starts to price in an earlier rate hike. This is also expected to support a further decline in EUR/USD.
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