Policy Matters

The Fed Waits on Rates

John L. Bellows
Portfolio Manager/Research Analyst

Executive Summary

  • At its June 15 meeting, the FOMC retreated from the hawkish rhetoric that it had used in May and lowered its growth forecast for this year to 2%.
  • The Fed’s cautious risk management stance has been supportive of markets and perhaps of US economic growth. We expect the Fed to maintain that stance unless and until there is a material change in the outlook.

Western Asset’s Portfolio Manager/Research Analyst John Bellows, PhD, summarizes the key points from yesterday’s Federal Open Market Committee (FOMC) meeting:

  • At its June 15 meeting, the FOMC retreated from the hawkish rhetoric that it had used in May. There was no mention in the post-meeting statement of rate hikes in the coming months. Moreover, five FOMC members downgraded their expectation for hikes this year from two hikes to only one hike. The absence of any specific guidance on hikes this summer, together with the downward movement in expectations, suggests a very cautious approach from the Federal Reserve (Fed).
  • It appears that ongoing questions about the FOMC’s growth and inflation outlook were responsible for the retreat. The FOMC lowered its growth forecast for this year to 2% (down from a 2.2% forecast in March, and down from 2.4% last December). This partly reflects the fact that growth in the first half of the year has come in well below the Fed’s initial expectations, but also that the long expected pickup in growth has simply failed to materialize. The disappointing May payroll point also raised the possibility that labor demand, which had been a bright spot in the recovery, may have slowed. On the inflation side, recent weakness of inflation expectations is a first order concern for the Fed, as Fed Chair Janet Yellen reiterated in her press conference. Inflation expectations stubbornly below the Fed’s target suggests that the risks to the inflation outlook remain to the downside, and the Fed has been forced to adjust policy accordingly.
  • In addition to a slower path of rate hikes, the FOMC has also downgraded its forecast for the level that rates will eventually reach. The FOMC currently thinks that short-term interest rates will top out around 3%, which is down from an expectation of closer to 4% a few years ago. While this is still above market pricing, the downward drift of the FOMC expectations reflects an expectation of materially lower nominal growth.
  • Interestingly one FOMC member expects the Fed to only hike one more time between now and the end of 2018. Clearly this member is not in the majority; nonetheless it appears that there is a real debate on the FOMC about the appropriateness of maintaining a hiking bias. More broadly, the divergence of views within the FOMC underscores the presence of very real risks outside of the base case forecasts. There is an argument to be made that those risks, which include both global and domestic concerns, lie primarily to the downside.

The Fed’s cautious risk management stance has been supportive of markets and perhaps of US economic growth. We expect the Fed to maintain that stance unless and until there is a material change in the outlook.

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