Dovish FOMC lowers expected rate path

FOMC drops its”patience” guidance, but won’t move at April meeting

The “dots” lower the Fed’s expected rate path substantially due to

… lower GDP forecasts for 2015 and beyond

…sharply lower Inflation forecasts in 2015, but little changed in 2016/17

…decline in the NAIRU estimate to 5.1% from 5.35% previously

Markets react enthusiastically

Patience” is gone, but no impatience

The FOMC no longer stated that it can be patient in beginning to start raising rates, but instead says that it is unlikely it will increase the Fed fund target at the April meeting. Chair Yellen added that the lift‐off may happen at any subsequent meeting afterwards. The statement says that this change in the forward guidance does not indicate that the Committee has decided on the timing of the initial increase in the target range. Ms. Yellen said the removal of this “patient” comment does not mean that the Fed is impatient to raise rates. She added explicitly that it didn’t have to be the June meeting, something one might have concluded from the removal of the patience comment that she earlier qualified as being not at the next two meetings. Yellen didn’t exclude the June meeting either, but couldn’t, of course, be more precise on the timing.

Timing lift-off is data-dependent, but coming closer

The statement however gave a hint on the timing, which is not calendar‐based: “The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.” The projections show that 15 out of 17 governors still expect these conditions to be fulfilled in 2015 (two see the lift‐off in 2016) and the governors median rate forecast for end 2015 of 0.625% (range 0.5 to 0.75%) suggest that the June or the latest the September meeting are most likely meetings to decide on the lift‐off. It remains conditional of course on a further improvement in the labour market and reasonable confidence in a return of inflation to 2% in a medium term perspective.

Governors lower rate path substantially

The reduction of the rate path was probably the most important novelty for the markets. Indeed, the median Fed fund rate forecast of the individual governors was substantially lowered to 0.625% for end 2015 (from 1.125% in December), to 1.875% for end 2016 (from 2.50% in December) and to 3.125% by end 2017 (from 3.625% in December). This means that the projected rate path is now lowered for the second consecutive time. Markets had a much lower path in mind, which might give them confidence that they have a better view on the pace by which the Fed will raise rates during the upcoming rate cycle.

The so‐called longer run (equilibrium) Fed funds rate remains at 3.75% (median), but 8 of the 17 governors had a 3.5% or lower (one governor) long run rate in their projections. This was a substantially bigger minority than the 4 governors who had such a projection in December 2014. So, the FOMC signalled that even after the lift‐off they would raise rates at a slow pace. Indeed, that’s slow as by the end of 2015, the unemployment rate is expected to reach the FOMC’s estimate of longer run rate (NAIRU, 5‐to‐5.2%). Under “normal” conditions, the Fed funds rate would have been at 3.75% by end 2015. Yellen justified this slow pace by lingering headwinds from the crisis and admitted that policy would still remain highly accommodative for some (long) time. For the lowering of the expected rate path by her fellow governors , she offered three possible explanations. First, the lower expected GDP growth in 2015, but also to a lesser extent in 2016/17 compared to the previous projections. Second, the lowering of the long run unemployment rate (which means that there is somewhat more slack than previously thought) and third the lower inflation, especially in 2015. By lowering their rate path, the FOMC shifted its expected path closer to that of the markets, as expressed by the Fed funds strip curve. The difference between the two had become extreme after the December meeting. The market pricing is nevertheless still less aggressive than the Fed’s expectations, with the Fed funds future now indicating that a full 25 bps rate hike is discounted by November 2015 and a second one between March/April 2016.

Yellen optimistic on economy

Despite the lowering of the growth forecasts, Yellen pointed out that growth was still expected to be higher than trend growth. Therefore, slack in the labour market would continue to diminish. Q1 growth was expected to have slowed due to household spending and export weakness. She admitted the role of a stronger dollar (also on lower import prices and inflation), but didn’t show too much concern about dollar strength, which was also the reflection of a strong economy. She saw a lot of improvement in the labour market, besides the faster than expected drop in headline unemployment rate. She called wage growth sluggish, but added that sluggish wage growth on its own was no sufficient reason not to tighten. Similarly, low inflation was no sufficient reason not to start raising rates. It was enough that the FOMC was reasonably confident that inflation will move back to its 2% target over the medium term. She said the FOMC was looking in this respect to a range of indicators, but interestingly specifically she said that a further improvement of the labour market conditions (less slack) was in itself an important indicator inflation would move back towards target. Also accelerating wage growth is a sign inflation would go higher.

Markets react enthusiastically

The change in forward guidance was a “hawkish” element, but it was more than offset by the lowering of growth and inflation forecasts and especially the sharp shift lower in the Fed’s rate expectations (dots). It gives the markets confidence that the Fed policy will remain accommodative for a long time. So, equities rallied higher (S&P +1.22%) and so did US Treasuries (up to 16.5 bps lower for 5‐year yield), while the dollar ceded ground against most other currencies EUR/USD spiked to 1.10). Gold jumped higher (to $1167/ounce from $1148). The decision (statement) was unanimously approved for the second time in a row. Even hawk Lacker voted in favour. Markets will now focus on the economic data to see whether the weak Q1 growth (winter weather) is followed by a rebound and if the labour market continues to tighten. If that’s the case, the lift‐off may still occur in June (or September) with a second rate hike likely between September and December.