As the Federal Reserve (Fed) starts the new year, there is one thing conspicuously absent from its communications: quantitative guidance. This is a notable change. In contrast to the date-based guidance of 2011 and 2012 and the threshold-based commitment of 2013 and 2014, the most recent Federal Open Market Committee (FOMC) statement lacked any quantitative guidance. The FOMC even appeared to retreat from softer forms of forward guidance, as it modified its expectation that rates will stay at zero for a “considerable period” to a weaker statement that it will be “patient” in normalizing policy. At this rate, it is likely that after March, FOMC statements will provide no forward guidance of any kind regarding the first rate hike.
Anticipating Fed policy has always required an economic forecast and a projection of the Fed’s reaction function. While forecasting US economic growth hasn’t gotten any easier, the absence of forward guidance will make assessing the Fed’s reaction function somewhat more difficult in 2015. Because it will be more challenging to correctly gauge the timing of the first rate hike, getting it right will be all the more important, likely differentiating investors and adding value to portfolios. Therefore, it is a worthwhile endeavor to try to figure out how the Fed will respond to the economic environment.
Here is how Fed Chair Janet Yellen explained the reaction function in her December press conference:
The references to the unemployment rate and core inflation provide little to no additional information because they are either in line with the consensus view (“further decline in the unemployment rate”) or exceedingly vague (“core inflation running near current levels”). The more important part of the statement is the reference to the inflation forecast, and specifically, that the Fed will raise rates only when it is “reasonably confident” in its forecast. However, this is an entirely subjective criterion. Not only are all forecasts inherently subjective, but it’s impossible to know or articulate in advance what would make policymakers “reasonably confident.”
So what are investors supposed to do with this subjective statement, and in particular, with the phrase “reasonably confident”? One approach (that we pursue below) is to evaluate the risks around the inflation outlook and make our own assessment of each one’s significance. To preview our conclusion: we think the risks to the inflation outlook are material and will likely cause the Fed to delay rate hikes while it works to develop “reasonable confidence.” As a result, we think the Fed’s first rate hike is unlikely to happen in June, and is more likely to happen sometime toward the end of the year. More importantly, we think the Fed will be responsive to these risks, such that any downside surprise could mean further delays in rate hikes. In this sense, Fed policy, and the front-end of the US yield curve, will be counter-cyclical in 2015.
In this piece, we will discuss four of the most important risks to the Fed’s inflation outlook: (1) falling oil prices, (2) US dollar appreciation, (3) additional easing from the European Central Bank (ECB) and the Bank of Japan (BoJ), and (4) falling global inflation. In each case, there is a plausible argument that any impact on inflation will be mild and transitory, which appears to be the Fed’s base case. However, there is also an argument that the impacts on inflation will be more lasting and pernicious. While these more pessimistic scenarios may not be the base case, they are likely to cause the Fed to be cautious in 2015, and are key in our reasoning that hikes will be somewhat delayed.
Background: The Fed’s Inflation Outlook
Although the Fed has consistently forecast that inflation will gradually return to 2%, inflation has remained stubbornly low since 2012 and even trended lower in recent prints. Core inflation, which excludes the more volatile energy and food-related components, has also remained below 2%, as shown in Exhibit 1, suggesting there is more to the forecast error than just surprises in oil prices.
We believe that the first half of 2015 is likely to be more of the same. The sharp fall in oil prices over the past few months will put significant downward pressure on inflation, which should keep inflation below the Fed’s 2% forecast. Given the magnitude of the decline in oil prices, year-over-year headline inflation is set to drop to around 1% by June with smaller but still noticeable impacts also likely on core inflation.
Of course, the Fed already expects some decline in headline inflation due to lower oil prices, and anticipated weakness won’t necessarily affect the forecast. Nonetheless, falling short of the inflation forecast for another year won’t go unnoticed, and at a minimum, may make it harder for the Fed to develop “reasonable confidence” in the forward-looking assessment.
Falling Oil Prices
Perhaps the most important development in financial markets in 2H14 was the spectacular (and largely unanticipated) fall in oil prices. Fed officials appear to be interpreting the decline as primarily supply-driven, rather than demand-driven. This distinction is extremely important and, if correct, is positive for growth and only temporarily negative for inflation. Support for the Fed’s supply-driven interpretation comes from a comparison of oil prices with other commodity prices. In particular, industrial metals and agriculture prices held up well in 2H14, even as oil prices plummeted, as shown in Exhibit 2. This suggests that the fall in oil prices was due to something specific to the oil market—such as new supply from US shale producers and continued OPEC production—rather than due to a broad decline in global demand.
Although compelling, this line of reasoning doesn’t rule out the possibility that softening global demand has also contributed to falling oil prices. In fact, estimates from the International Energy Agency suggest that as much as two-thirds of the gap between oil supply and demand is due to a drop in demand, with particularly significant declines from Japan, Europe and China. If falling oil prices are due to softening global demand, the implications for the US economic and inflation outlook are much more negative. A demand slowdown would pose a risk to US growth by weakening exports and putting additional stress on financial markets, which could further slow consumption and investment. In addition, a global demand slowdown would likely lower global inflation, making it even more difficult for US inflation to rebound.
While we think the supply-driven interpretation of lower oil prices has merit and share the view that implications of a supply-driven decline would be broadly positive, the Fed has to be cognizant of the possibility that falling oil prices could be signaling something about global demand. That concern (and the attendant risks for growth and inflation) is the first reason why the Fed will need to be cautious in its outlook.
US Dollar Appreciation
US dollar appreciation is another major risk that requires the Fed’s attention. On a trade-weighted basis, the US dollar appreciated 8% in 2014, with more than half of the appreciation coming in 4Q14 alone. The recent movement has followed a trajectory similar to the 1994 and 1999 Fed hiking cycles, in which the dollar ended up appreciating by 19% and 22%, respectively, as shown in Exhibit 3. An optimistic interpretation of the dollar appreciation is that the combination of relatively strong US economic growth and higher US interest rates attracts foreign investors to US markets and the resulting capital flow pushes up the value of the dollar. If this is the primary driver of dollar appreciation, then there is little reason for concern from the Fed.
However, there are at least two reasons why US dollar appreciation may be more worrisome. The first is that it tends to lower domestic inflation, both by lowering the dollar-price of imports and the prices of domestically produced goods that compete with foreign goods for market share. Some of the recent weakness in goods price inflation in the US may already be reflecting the impact of the stronger US dollar. The second and probably more important reason for the Fed to be concerned is that some part of the dollar appreciation may be due to “flight-to-quality” flows. While perhaps a subtle distinction, there is an important difference between foreign capital flows into the US to capture higher returns and foreign capital flows into the US to avoid political or economic catastrophes abroad. The possibility of the latter scenario is a concern for the Fed and will add to its caution regarding the US outlook.
Additional Easing from the ECB and BoJ
The prospect of additional easing from both the ECB and the BoJ in 2015, as shown in Exhibit 4, is an important component of every economic forecast and is likely something the Fed is carefully considering. The hope is that additional easing from foreign central banks will lift both financial markets and the real economy, which in turn would brighten the prospects for the US recovery and increase the Fed’s confidence in its outlook. In a recent speech, New York Fed President Bill Dudley suggested that if ECB and BoJ easing caused global financial conditions to loosen (i.e. higher equity prices and lower bond yields), it could actually lead the Fed to be faster in normalizing policy.
Unfortunately, the implications for the US are not entirely one-sided. First, there is the very real possibility that more quantitative easing will fail to generate the desired boost to demand in either Europe or Japan. A second complication is that additional easing will likely lead to further dollar appreciation, which may in turn lower inflation in the US. Finally, the fact that the ECB and BoJ are resorting to more extreme measures is an indication of just how entrenched the problems of weak demand and low inflation are in those economies. The cautionary examples from Europe and Japan starkly illustrate the downside risks of tightening monetary policy prematurely. While Fed officials are certainly hoping their international colleagues are successful, we think it’s likely that the developments in Europe and Japan are making Fed officials more cautious rather than optimistic as they formulate their own outlook for the US.
Falling Global Inflation
The problem of low inflation is not unique to Europe and Japan. In 2014, the median inflation rate in both emerging market (EM) and developed market (DM) countries was near its lowest level in 30 years, and is expected to remain near these low levels into the foreseeable future, as shown in Exhibit 5. For many countries, falling inflation is a welcome development. This is especially true for EMs where central banks have struggled with persistently overshooting their inflation mandates. If inflation stays low in these countries, their central banks can turn their attention to supporting growth and financial markets through looser monetary policy. Indeed, recent easing from the People’s Bank of China has been made possible, in part, by falling Chinese inflation.
While falling global inflation may be a boon for certain EMs, it is almost certainly a concern for DMs where inflation is too low, as is the case in the US, Europe and Japan. Inflation rates are interconnected through globalized trade, and the US risks importing Chinese deflation at the same time that it imports Chinese goods. More fundamentally, there is a possibility that falling global inflation is due to weak and softening global demand. While some amount of monetary easing by EM central banks may provide a near-term boost, we think it is unlikely that it would completely insulate the global economy from a more protracted demand slowdown. This is yet another reason for the Fed to watch global inflation with a fair amount of caution.
Conclusion and Investment Implications
At the start of 2015, the Fed finds itself in the relatively new situation of not being constrained by quantitative guidance, and it will soon find itself not tied by any guidance whatsoever with regards to the first rate hike. Instead, Chair Yellen has said that the timing of the first hike will depend on the Fed’s confidence in its inflation forecast. This is an inherently subjective criterion, and, as such, investors are forced to make their own assessments of the risks in order to anticipate how confident the Fed will be in the forecast. Our view is that the risks to the inflation outlook are material so the Fed will likely delay hikes somewhat as it develops “reasonable confidence” in its inflation outlook.
To some extent, a delayed Fed reaction is already priced into the US rates market. At the beginning of the year, the US rates market was pricing two Fed hikes in 2015 and perhaps another four hikes in 2016. However, this falls short of the FOMC’s guidance, as presented in its quarterly Statement of Economic Projections, which suggests that Fed officials are anticipating three hikes in 2015 and as many as five or six hikes in 2016, as shown in Exhibit 6.
Rather than focusing on the level of rates, the more important implication of our view is that Fed hikes will be responsive to developments around the world in so far as these developments generate further downside risks to the inflation outlook here in the US. Specifically, if any of the risks enumerated above were to develop such that the inflation outlook were further called into question, we think the Fed would respond by delaying rate hikes. This would in turn cause yields on the front end of the US curve to move lower, meaning that short-dated Treasuries would outperform. As such, the front end of the US yield curve could provide a valuable offset to credit positions in an environment of weakening global growth.