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The few small changes in the FOMC’s policy statement this month reflected a slightly more upbeat short-term view of the economy, though in her press conference Ms Yellen was quick to communicate a dovish tone – not least by repeatedly stressing the uncertainty inherent in the FOMC’s economic forecasts. The Fed’s message to the market continues to be ‘steady as she goes’; so far, this is working. But financial market froth could be back to haunt the Fed sooner rather than later.
The FOMC appears to have adopted a slightly more positive view of the near-term outlook for the economy since its last meeting. According to this month’s policy statement, economic activity has “rebounded” (rather than “picked up”), labour market indicators have “generally showed further improvement” (an upgrade from the “mixed, but on balance showed improvement” phrase used previously) and business investment has “resumed its advance” (rather than “edged down”).
However, any whiff of a hawkish undertone was somewhat tempered by the message from the Summary of Economic Projections and Ms Yellen’s remarks at her press conference. The Fed lowered its range of forecasts for real GDP growth this year by 0.7 percentage points to 2.1%-2.3% – though much of this will have been a simple arithmetic consequence of downward revisions to the Q1 GDP data. Its estimates for 2015 (3.0%-3.2%) and 2016 (2.5%-3.0%) were left unchanged. At the same time, projections for unemployment were lowered by 0.2 and 0.1 percentage points for 2014 and 2015, respectively. And the Fed’s outlook for core PCE inflation was broadly unchanged through to the end of 2015. With regards to the Fed Funds Rate (FFR), the FOMC’s median projection for the end of 2015 edged up by a mere 12.5 basis points to 1.125%, and by 25 basis points to 2.5% for 2016. That is presumably a reflection of the modest downward revision to unemployment. Still, any optimism from these modest increases was checked by the Fed’s lower forecast for the long-term FFR, which fell 25bps to 3.75% – a relatively pronounced shift even if one accounts for the changes in the FOMC’s composition this month. That is presumably a reflection of the slight downward revision to the FOMC’s estimate of longer-run real GDP growth, from 2.2%-2.3% to 2.1-2.3%.
This downward revision to what are effectively judgments about trend growth and the natural rate of interest may be an indication that fears about the possibility of ‘secular stagnation’ are creeping into the minds of at least some on the FOMC. It perhaps explains why Ms Yellen made repeated references to uncertainty during her press conference. For example, when asked if she had confidence in these economic forecasts, her response was “no, because there is uncertainty”. And, while FOC officials continue to expect the FFR to remain below levels “viewed as normal in the long run…for some time”, Ms Yellen was careful not to specify a particular calendar timeframe, saying instead that it will depend on how the economy progresses. At the same time, we detect the influence of vice-Chair Fischer’s well-known views on forward guidance (“you cannot expect the Fed to spell out what it’s going to do…because it doesn’t know”). In general, Ms Yellen’s comments in the Q&A were a re-affirmation of her dovish mindset. She downplayed the recent pick-up in inflation, to 2.1% on the headline CPI measure, as “noisy”, and pointed again to the importance of broad measures of unemployment as gauges of the labour market’s underlying health.
Investors’ reaction was relatively muted. Equities moved a tad higher, the 10-year Treasury yield edged lower and the dollar weakened somewhat. Interestingly, the market’s rate hike expectations are slower and later than those indicated by the FOMC’s median ‘dots’ – Fed Funds future contracts for December 2015 and 2016 stand below the Fed’s estimates, as our chart illustrates. Are investors sniffing a weaker growth environment ahead? Or have they been convinced by Ms Yellen that shifts in the ‘dots’ do not really have much informational content? We think there is some truth in both these statements. But, to the extent that this divergence is a sign of investor inertia, fuelled by reassurances for a highly accommodative monetary outlook as far as the eye can see, we also regard it as a potential harbinger of higher volatility ahead.
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In this regard, Ms Yellen remains sanguine about risks to financial stability, which she characterised as “moderate”. Still, we would highlight the fact that asset prices are, in general, higher than they were before Mr Bernanke lit the taper. The S&P 500 has gained some 15% – driven largely by an increase in the PE ratio – while EM equities have virtually retraced all of their losses since May 2013. Credit spreads have tightened further and measures of volatility are even more depressed at present – for example, the VIX has dropped to its lowest level since early 2007. With the potential for a spike up in oil prices against the backdrop of increasing tensions in Iraq, the remarkably sanguine attitude of investors is perhaps a little puzzling. We do not think that Ms Yellen is hoping market participants will take a cue from her references to uncertainty and dial down their risk appetite. Rather, it seems to us that, as the Fed moves further away from the uncharted waters of QE, it is also becoming more comfortable with a frothy financial asset price backdrop and the viability of its ‘put’.
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A dovish attitude appears to be working just fine for the Fed so far. But this is increasingly dependent on a well-behaved growth/inflation mix. And with most financial asset prices having, for the most part, shrugged off the taper-tantrum, financial stability concerns may come back to haunt the Fed sooner rather than later.
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