As expected, Federal Reserve policymakers held the Fed funds target at 5.25% for the fifth straight meeting on Jan. 31. With rate hikes out of play—the Fed's last quarter-point tightening came in June, 2006—financial markets instead zeroed in on the subtle tailoring of the Federal Open Market Committee statement, as policymakers tried to adapt their core views about inflation and the economic outlook to the recent rash of firmer indicators.
Despite some verbal hedging at the December meeting against risk of a more "mixed or moderate" growth trajectory, the Fed evidently felt more confident that its central projections remain on track, but also saw core inflation "improving modestly."
As anticipated, the Fed took into account the improved economic tone since its last meeting by replacing the cautious language on economic growth in its December statement with a more optimistic perspective in the January communique. The Fed said recent indicators have suggested "somewhat firmer economic growth" amid "some tentative signs of stabilization" in the housing market.
The view in December had been gloomier—economic growth had "slowed" and this reflected a "substantial cooling" of the housing market, with "mixed" economic indicators, though the economy was still expected to expand at a "moderate pace over coming quarters". This last view carried over to the January statement.
But at the same time, the Fed said "readings on core inflation have improved modestly," which eclipsed the previously held opinion that core inflation remained elevated. It still maintained its expectation that inflation pressures will moderate over time, and that the high level of resource utilization had potential to sustain inflation pressures.
The January statement was also stripped of references to energy prices (which came down), contained-inflation expectations (presumably still friendly), cumulative effects of monetary policy, and other factors. It would appear from the shift in both its economic and inflation assessments that the Goldilocks scenario—with conditions "not too cold or hot" for the economy—is consistent with a steady Fed for months to come.
More of the Same?
Bond yields surged on Jan. 31 as the economy proved much more resilient than the Treasury market had credited. The drop in energy prices and gains in equities have restored consumer confidence, which hit the highest level in nearly five years, supporting a solid fourth-quarter run of retail sales and feeding back into the 3.5% gain in fourth quarter GDP reported on Jan. 31. Meanwhile, core readings on consumer prices, producer prices, and employment costs have been relatively benign, as the Fed pointed out.
Even housing starts have shown signs of recovering from their low water mark in October, and, of course, employment has remained strong. Plus, the jobless rate is expected to match a cyclical low of 4.4% in the January employment report, scheduled for release Feb. 2.
Fed funds futures, a trading vehicle for market pros to vet on interest-rate moves, nudged fractionally higher after the FOMC's kinder, gentler statement. Traders zeroed in on the shift in the inflation outlook. The futures market expects an unchanged policy stance through June. However, some slender hopes for a rate cut as the next move have filtered back in.
We at Action Economics see little risk of the Fed reverting to an easing mode any time soon and, in fact, the increasing cohesion in the economic outlook suggests that Ben Bernanke & Co. will at minimum hold steady for the foreseeable future.