FOMC leaves the stance of policy unchanged as expected - Westpac

Analysts at Westpac explained that at its January 2018 meeting (Chair Yellen’s last), the FOMC left the stance of policy unchanged as expected. 

Key Quotes:

"Alterations to the decision statement versus December were subtle, but together pointed to greater confidence in the Committee’s ability to meet its objectives via “further gradual” interest rate increases. “Gains in employment, household spending, and business fixed investment have been solid” and that “Inflation on a 12 month basis” is now expected to “move up this year” rather than “remain somewhat below 2 percent in the near term” signal the Committee’s belief in the sustainability of late-2017’s broad-based momentum and its likely result, steady progress towards the FOMC’s medium-term objective. 

Additional evidence of this progress towards the 2.0%yr target was found in the discussion of market inflation expectations. Previously characterised as simply having “remain[ed] low”, in the January statement there was an upgrade to “measures of inflation compensation have increased in recent months but remain low”. With the market increasingly on the look-out for a stronger inflation pulse, the next test for firming inflation expectations will be the household sector. 

As yet, “survey-based measures of longer-term inflation expectations are little changed”. Wages growth arguably remains the greatest impediment to household inflation expectations as well as consumer spending. Simply, despite an unemployment rate below its full-employment level and ongoing job creation well in excess of population and labour force growth, wages are yet to meaningfully accelerate. That said, the December quarter may be the first step in this process. Also released overnight, the Employment Cost Index reported that annual wage growth in the private sector accelerated to 2.8%yr at December; that compares to 2.4%yr at June and 2.6%yr in September. Importantly, growth in benefit compensation was less of a drag on total pay for the sector, annual growth having risen from 1.8%yr a year ago to 2.4%yr. These are not strong outcomes by any means, but are a clear acceleration from the abnormally low pace of gain post GFC. 

For the Committee, they will be evidence that wages are responding to reduced labour market slack and that, with the economy at full employment and above-trend growth continuing, a “sustained return to 2 percent inflation” should be anticipated. It is worth noting that many firms have responded to President Trump’s tax plan with one-off and recurring increases in compensation. Hence this uptrend should persist through 2018. A crucial point not discussed in the statement is financial conditions. Coming into 2018, the US economy has received a material boost on this front, with the US dollar having fallen to three-year lows and term interest rates remaining around the level seen in December 2016 – despite four rate hikes since, and three more being priced in. Further, the equity market has seen strong gains, and national house price growth has continued at a multiple of income growth, substantially increasing household wealth. All of these factors should provide significant support to the US economy in 2018 – arguably considerably more than President Trump’s tax reform. 

The January meeting and recent US data have given us greater confidence in our view that the FOMC will raise the fed funds rate at each of the March; June and September meetings. What occurs past that point will depend critically on the effect of the FOMC’s concurrent balance sheet reduction – at maximum effect from late-2018. This historic shift in the stance of policy, along with the three rate hikes by September, should see financial conditions tighten materially, holding inflation near the FOMC’s target and allowing the rate hike cycle to enter an indefinite hiatus."