FOMC to Keep the Powder Dry for a Second-Half Rate Hike

A preview from Bloomberg Intelligence

Fed Chair Janet Yellen News Conference Following FOMC Meeting
Photographer: Andrew Harrer/Bloomberg *** Local Caption *** Janet Yellen

The June FOMC meeting is a watershed moment for the financial markets. It is the first in which interest rate increases are theoretically possible given previous guidance from monetary policy makers. A rate increase is extremely unlikely at this point, however, on account of the weak performance of the economy in the first quarter. Instead, committee members will focus on economic momentum heading into midyear. They will try to determine if the economy is on a trajectory that can readily withstand the onset of rate increases sometime in the second half of 2015. Policy makers will provide plenty of fodder for market participants to digest.

In addition to the post-meeting statement, there will be updated economic forecasts, a refresh of the “dot plot” and a post-meeting press conference from Chair Janet Yellen.

What to Expect:

  • Rate increases are now possible, given the Fed’s previous guidance indicating that June would be “in play”. However, the probability of a rate increase is extremely low. It would be a shock to the financial markets in the current environment, and policy makers are keen to avoid stoking market gyrations. Expect the first move to be clearly telegraphed well in advance.
  • Policy makers will modestly firm their characterization of recent performance in the economy and continue to emphasize that the soft patch at the start of the year was at least partly transitory.
  • The labor assessment is due for a modest upgrade given the re-acceleration in hiring since the March jobs report (the last report released ahead of the April FOMC meeting).
  • Policy makers may express modest improvement in their confidence that inflation is stabilizing, but they will have to reconcile this with the recent backslide in the core PCE deflator.
  • In the post-meeting press conference, expect Chair Yellen to push to keep second-half rate hikes as an option, while steering clear of an explicit commitment.
  • The largest changes to the economic projections are likely to be concentrated in the near term, particularly for GDP growth. It will be difficult to reach the Fed’s baseline forecast given the soft trajectory of first-half growth, so the 2015 GDP projection will probably be trimmed.
  • The “dot plot” is likely to remain split between one and two 25 basis point rate increases this year. The median longer-run projection for the fed funds rate -- which is viewed as the “neutral” level of fed funds -- is on the cusp of drifting down to 3.5 percent.
  • Given the Fed’s desire to clearly telegraph the commencement of liftoff, market participants should expect a significant modification of the FOMC statement at the meeting preceding the first hike. This is unlikely to occur in June, which in turn will further reduce the likelihood of rate action at the July 28-29 meeting.
  • Bloomberg Economics continues to expect the initial rate increase to occur in September.

Based on previous guidance from policy makers, the June FOMC meeting was the earliest potential date under consideration for a fed funds rate increase. However, the weak tone prevailing over much of the economic data in the first part of 2015 has virtually eliminated the possibility for action at this time. Instead, the meeting will present policy makers with an opportunity to refine their message and shape expectations for interest rate policy later this year. Reiterations that second-half rate increases remain viable from several influential members of the FOMC should not be taken lightly, as this reflects their desire to move away from a crisis-era stance of policy accommodation.

A 2015 rate liftoff will be possible if two preconditions are met: First, the economy needs to continue on a path toward full employment and moderately faster inflation. Second, the Fed needs to sufficiently convince market participants that the initial rate increase (or increases) will be extremely gradual, so as to avoid a dramatic appreciation of the dollar/backup in interest rates/pullback in the equity market, which could tighten financial conditions to a greater degree than desired. As a result, the June meeting has become a signal event, not an action event. There will be a number of channels through which the Fed can enhance its signal, including the tone of and forward guidance in the FOMC statement, the updated economic projections, the interest rate “dot plot” and Chair Yellen’s post-meeting press conference.

The recent improvement in the labor, housing and retail sales data are likely to result in moderate upgrades of these sectors, as well as the overall growth assessment, in the official policy statement. The previous statement said, “[G]rowth slowed during the winter months, in part reflecting transitory factors” and “underutilization of labor resources was little changed.”

In particular, policy makers will be encouraged by the recent improvement in household spending. Conversely, the previous assessments of business fixed investment (“softened”) and exports (“declined”) will almost certainly remain gloomy. The factory sector remains largely stuck in the doldrums -- which was evident in the latest industrial production data -- following an outright contraction earlier this year. This may exacerbate concerns that transitory factors only partly explain first-quarter weakness.

The inflation data are not exactly cooperating with policy makers' hopes and expectations. Not only has inflation not improved over the past few months, as the Committee has repeatedly suggested it would, but in April, the core PCE deflator decelerated slightly to 1.2 percent year over year from 1.3 percent previously. Yellen's remarks at the press conference and possibly the FOMC statement are likely to dismiss that deceleration due to the "transitory factors" the Fed has previously cited as the cause of both soft inflation and slow growth in the first quarter.

Look for Yellen to emphasize that realized inflation data are lagging indicators, whereas the Fed needs to set policy based on its expectations, as shaped by more forward-looking labor data. That would be consistent with her previous comments and should give the Fed chair enough ammunition to project an air of confidence without resorting to any more abstruse inflation measures such as trimmed means or medians.

Headline vs. Core Inflation

While survey measures of inflation expectations are near recent lows, the Fed has already shown great forbearance with both these particular levels and, more generally, monthly fluctuations in these indicators. Though the recent recovery in TIPS breakevens will be welcomed by policy makers, they are likely to receive a similarly cool reception. The FOMC will be mindful that some of the price action is attributable to the recent moves in fixed-income markets toward higher yields across the board. The balance of all these factors supports a cautious approach to the inflation data, so the description that market-based measures of inflation compensation “remain low” will probably remain in the statement.

Inflation Expectations in Surveys and Markets

Along with the statement, the Fed will also publish an updated Summary of Economic Projections. Bloomberg Economics does not anticipate major changes to the outlying years or the “longer run” projections. However, there are likely to be some changes to the 2015 forecasts in light of recent data, specifically the output stall in the first quarter which has been followed by a tepid recovery in the current quarter. It will be difficult to achieve the midpoint of the previous GDP forecast of 2.5 percent (fourth quarter over fourth quarter). Given the 0.7 percent contraction in the first quarter of 2015, growth would need to average roughly 3.5 percent in the remaining quarters of the year to reach the previous projection. This is a tall order, particularly since the current quarter appears to be on track to achieve growth closer to 2.5 percent. The revised estimate is likely to drift a few tenths lower toward 2.25 percent. The baseline forecasts for unemployment (5.1 percent), headline inflation (0.7 percent) and core inflation (1.4 percent) all appear to remain reasonably within reach.

The last update of the “dot plot” in March showed a significant reduction in the likely path of policy in 2015, as policy makers removed two 25 basis point increases. It would take only two rate hikes to hit the current year-end target of 0.50-0.75 percent. Policy makers are probably unwilling to cede an additional rate increase at present, so the current projection is likely to remain intact. They will similarly see little need to alter the projected pace of tightening at this time, so watch for the implied pace of 125 basis points per year to persist. One development which may not be on investors’ radar is the potential for the median point of the long-term (i.e. neutral) fed funds rate to decline by a quarter-point to 3.5 percent. It barely remained at 3.75 percent in the March dot plot.

Whether the Fed actually manages to raise interest rates off of the zero bound this year is yet to be determined -- by the economic data, of course. While policy makers will refrain from any explicit commitments, they will remain resolute in at least keeping the option available. They will accomplish this by preventing market expectations from shifting too far into the future. Bloomberg Economics retains the view that the policy liftoff will occur in September. This will have given officials the benefit of seeing the second-quarter GDP report, three more jobs reports and several more indicators which will shape expectations regarding the velocity of growth heading into the second half of the year.

This post is courtesy of Bloomberg Intelligence Economics.

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