In December last year the US Federal Reserve tightened monetary policy, albeit by only a quarter point, citing the ‘considerable improvement in labour market conditions’ and an expectation that inflation would gradually recover to the desired 2% level. The accompanying statement emphasised that further rate increases would be gradual, although the projections released at the time from the 17 FOMC participants (the ‘dot plot’) indicated a median expectation that 2016 would see four further quarter point rises.
The market was not convinced but the latest ‘dot plot’ , released in mid-March, was still a surprise to many, as the median expectation now showed only two rate increase by year-end. True, growth was now projected to be marginally weaker in 2016 and 2017 but the unemployment rate was also forecast to be lower, falling to 4.5%, against 4.8% in the long run. Inflation ( the Fed’s measure is the personal consumption deflator) was expected to end the year at 1.2%, down from the previous 1.6% forecast, but the core rate forecast (defined as ex food and energy) was unchanged at 1.6%.
Monetary policy is deemed to have ‘long and variable lags’ so one might think that unemployment around the Fed’s desired level alongside an expectation that inflation will pick up would be consistent with steady rate increases. let alone a change to a more dovish rate outlook. Core inflation has actually picked up of late , rising at an annual 2% rate over the past three months, and the annual rate is 1.7%, which is above the Fed’s expectation for the year-end. Yet Janet Yellen, in a recent speech, emphasised that low inflation expectations were now a concern. Survey measures had shown a fall while market based measures had also declined ; the 10-year break-even inflation rate fell to 1.2% in February. She highlighted the risk that lower expectations would feed into wage and price setting, so increasing the probability of inflation remaining below target for longer. The Fed Chair also flagged the possibility that the unemployment rate could fall much further without triggering wage inflation and also pointed to international risks to the US economy.
So it is now very difficult to see what would trigger a rate rise in the coming months. A further improvement in the labour market does not seem a sufficient condition and higher spot inflation may not be sufficient either, given the emphasis put on inflation expectations. In fact the latter is heavily influenced by spot inflation anyway, particularly high frequency purchases like fuel, and market expectations have actually risen again of late, perhaps driven by the rebound in oil prices in March. Crude prices have fallen back again in the past week, however, and this may dampen expectations again.
The Fed funds future for December is trading at 0.5%, so the market is no longer convinced we will see any rate increase this year. Central banks generally tread a line between Discretion on policy or following a more Rules based approach and the former is driving the Fed at the moment, which makes for flexibility but makes it very hard to read their next move.