This Fed Is a Dove in Hawk's Clothing

The central bank's actions are ultimately dollar bearish, gold bullish and supportive of equities.

Fed doves take flight.

As the dust settles from the Federal Reserve’s decision to raise interest rates, it’s important to look through the short-term volatility to see some of the broader market implications. Despite the market reaction, the Fed’s actions are dollar bearish, gold bullish and supportive of equities -- especially given the dovish turn in Federal Open Market Committee member forecasts of future rates. Yes, dovish.

The weak consumer price index report released just hours before the Fed acted Wednesday means the central bank shouldn’t be under pressure to increase rates. Even as policy makers raised the target federal funds rate by 25 basis points -- something that is usually seen as fundamentally dollar bullish -- the mean estimate for the rate for 2017, 2018 and 2019 all fell even though the median forecasts appeared virtually unchanged. The mean forecasts, rather than the median forecasts, are the numbers to watch because they better reflect changes in the distribution of FOMC member policy expectations. 

The statement that accompanied the rate decision included the FOMC’s intention to “normalize” its balance sheet, but this is likely to be tougher than the Fed is making it sound. A similar strategy was tried by the European Central Bank, which shrank the size of its balance sheet from 3.1 trillion euros in June 2012 to 2 trillion euros in September 2014. That turned out to be too much for the euro zone economy to handle. Although the euro zone was in a recession and recovered during that time, the regional manufacturing PMIs weakened further in 2014, at the end of this ECB balance sheet normalization. And it threatened to send the euro zone economy back into recession.

The ECB’s attempt to reduce its balance sheet was a complete failure, and it almost resulted in a recession. Policy makers were forced to reverse course, and it necessitated the massive quantitative easing program the ECB has since been implementing since, putting the current size of the ECB balance sheet at 4.1 trillion euros ($4.57 trillion) -- more than double the level at the end of its reduction program. In other words, a one-third reduction in the ECB balance sheet subsequently necessitated its doubling from the newly reduced level. This shows how difficult balance sheet “normalization” could be for the Fed.

For all its talk of balance sheet normalization, the Fed may similarly struggle. After all, once hooked on the sauce of cheap money, financial markets don’t want to see the punch bowl taken away. If the ECB offers a lesson, it’s that shrinking the balance sheet can necessitate a rather quick, and even more drastic, expansion.

Given the dollar bearish implications of the Fed’s mean rate forecasts and the FOMC’s likely challenges with balance sheet normalization, future policy should prove supportive of gold prices, which have trended higher since December 2016. Both fundamentals and technicals have supported gold prices.

The June Fed decision also holds implications for equity markets that are near all-time highs. While equities face downside risks if U.S. fiscal policy fails, they are likely to respond favorably from lowered Fed rate forecasts. The Fed decision indicates that the economy can withstand rate hikes, which is also indicative of positive growth dynamics. But the low level of current U.S. inflation, despite near full employment, does not present an urgent need for Fed monetary tightening. This is goldilocks Fed messaging. However, balance sheet normalization could still upset the equity apple cart -- when (and if) it happens later this year, as the Fed has indicated.

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