We knew that yesterday’s FOMC meeting was an important one, and it certainly didn’t disappoint. The S&P rallied 30 handles and the US dollar index traded in a 3 big figure range.
As expected Yellen & Co. removed the controversial word “patient” from the statement, but that was all the hawks got. Everything else was dovish. Big time.
The focus of many market participants was the Fed’s walking down of interest rate expectations via the infamous “dots.”
The chart above shows the magnitude of the Fed’s downgrading of projected rate increases. The purple line shows the latest median projection. It is significantly lower than the dark blue line which was the Dec 2014 projection.
Although the Fed did indeed lower their expected rate hikes, I have long held the belief that the dots are all bullshit. They don’t mean squat. They have about as much meaning as a Wall Street analyst’s price target. As a stock’s price increases how many times have you seen an analyst leave his target unchanged and then issue a sell recommendation when it reaches the target? Me neither.
The dots are nothing more than the Federal Reserve’s hopes of where rates might be if everything goes right. I don’t buy that the lowering of the dots were the driving factor behind yesterday’s move.
In my book, there were two important parts to yesterday’s developments that drove the market moves.
The first (and most important) change was contained in this paragraph:
Consistent with its previous statement, the Committee judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting. 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. 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.
The sentence “raise the target… when it has seen further improvement in the labour market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term” is the real policy change. The Fed has firstly stated that the current labour market situation is not good enough. They need to see further improvement. So even though they had previously indicated that the current employment levels were enough to warrant rate increases, they have once again changed the goal posts. That’s not surprising, the Phillips Curve hasn’t worked in a decade, so it makes little sense to raise rates because the labour market is tightening up a bit. But the real game changer is the commitment to no rate hikes until the FOMC committee is reasonably confident that inflation will move back to its 2 percent objective over the medium term. There has never been a rate hike to start the tightening cycle without inflation running above the 2 percent target, and this Fed has just told you they won’t be the first to change that fact.
Yesterday I showed you this chart of PCE Core Inflation:
This has become the most important chart out there. The Federal Reserve has just promised that rates are not going to be raised until they are confident inflation will stay above their target. Not only does it need to tick above the target, they need to be confident that it will stay above the 2 percent level for the medium term.
I don’t think the market appreciates the full extent of ramifications from this statement. Rates are not going up until inflation hits their target. Full stop. It doesn’t matter if the unemployment rate is 4% – they aren’t going to raise rates. Look at the Fed’s statement carefully again. It wasn’t an OR that joined the two conditions, it was an AND. We need further improvement in the labour market AND 2 percent inflation. The bar for raising rates has been set quite high.
The other surprisingly dovish part of yesterday’s FOMC press conference was Yellen’s reference to the strong US dollar. She repeatedly said that the recent strength was going to keep prices down. There could be no doubt that the Fed is concerned about the recent rally. The Fed is not supposed to comment on the US dollar as it is under purview of the Treasury, but Yellen went as far as she properly could to indicate that US dollar strength was a headwind to the economy.
Although the Fed’s removal of the word patient has diminished forward guidance for zero rates, the new guidelines the Fed has outlined for the conditions necessary for a rate hike are more dovish than the market realizes. Rates are not going up until the Fed sees inflation above target and employment continues to improve. There is little to suggest that this will happen anytime soon.
This FOMC meeting marked the 50th meeting the Fed has left rates at zero. They just made it even more likely that number will get even larger.
Thanks for reading,