Fed Takes the Middle Path, Leaves Rates Unchanged

Stocks climbed with Treasuries, while the dollar declined after announcement

The Federal Open Market Committee (FOMC), which met amidst a slew of dismal economic developments, left short-term interest rates unchanged while it waits for more concrete evidence to emerge about the progress of the economy toward its pre-set 2% inflation target. Federal Reserve Chairperson Janet Yellen, in her speech to central bankers and economists at Jackson Hole, Wyoming, on August 26th, 2016, had said that the continued solid performance of the labor market has strengthened the probability of a U.S. rate hike in the coming months. Yellen had hinted at a possible rate hike in September 2016, if the August 2016 jobs data maintain the same pace as seen in July 2016. Yellen had also remarked that she did not need to see actual inflation rising toward 2% in order to hike interest rates. While inflation would reach their 2% target over the next couple of years, gradual and timely moves were required to sustain employment and inflation nearer to the Fed’s statutory objectives.

At a two-day meeting on September 20-21st, 2016, in Washington, the FOMC said that near-term risks to the economic outlook appeared roughly balanced. The committee said that although the case for an increase in the federal funds rate had strengthened, it would wait for further evidence of continued progress toward its objectives. The sixth straight decision to leave interest rates unchanged comes amid risks from abroad and inconsistent signs of economic growth.

The FOMC also acknowledged that GDP growth this year has been slower than expected, notably in Q2 FY16, which pegged growth from April through June 2016 at an annualized rate of 1.3%, one-third the level projected by the Fed in January 2016.

More dissent over rate hike

Source: Federal Reserve, Bloomberg
Source: Federal Reserve, Bloomberg

Three officials, the most since December 2014, dissented in favor of a quarter-point hike. Esther George, president of the Kansas City Fed, voted against the decision for a second straight meeting. She was joined by Cleveland Fed President Loretta Mester in her first dissent, and Eric Rosengren, head of the Boston Fed, whose previous dissents called for easier policy.

Policymakers see two rate hikes in 2017

At the start of the conference, Yellen said that the committee’s decision does not reflect a lack of confidence in the economy. She also said that since the monetary policy is only modestly accommodative, there appears little risk of falling behind the curve in the near future.

After the Fed announced its decision, stocks climbed with Treasuries, while the dollar declined and gold rallied. The Standard & Poor’s 500 Index extended gains, while a gauge of the U.S. yield curve flattened as the shortest-maturity debt underperformed.

The Fed’s dot plot, used to signal its outlook for the path of interest rates, showed that officials expected a 0.25% increase in 2016. Three policy makers projected that keeping rates unchanged this year would be most appropriate. Officials scaled back expectations for hikes in 2017 and over the longer run. Policy makers see two rate hikes in 2017, down from their June 2016 median projection of three hikes.

Source: Federal Reserve, Bloomberg
Source: Federal Reserve, Bloomberg

The Fed said that although the unemployment rate is little changed in recent months, job gains have been solid, on average, while household spending has been growing strongly. The Fed will continue to closely monitor inflation indicators and global economic and financial developments over the next few months. The target range for the benchmark federal funds rate change remains at 0.25% to 0.50%, static since the 0.25% increase in December 2015, after seven years of near-zero interest rates.

While Fed officials say that the economy is experiencing a new normal, policy makers have scaled back their median projection of the long-term interest rate to 2.9% from 3% predicted in June 2016. Fed officials have also cut their median growth projection for 2016 to 1.8% from 2%. Inflation is now projected at 1.3% in Q4 FY16, down from the forecast of 1.4% in June 2016.

Inflation is still running below the Fed’s 2% target, after inching up earlier in the year. Core inflation, which excludes food and fuel costs, is firmer, though still undershooting at 1.6%. Policy makers have projected that inflation will reach the 2% target only in 2018.

Source: Bloomberg
Source: Bloomberg

Meanwhile, a gauge of market-based expectations watched by the Fed is projecting a pace of price gains of about 1.5% in the next 5 to 10 years. The focus now shifts to the Fed’s meeting on December 13-14th, 2016, with economists predicting a 54% probability that the Fed will raise interest rates, depending on how the economy, inflation and markets perform in the coming months in a run-up to the presidential election.

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