Schroders Quickview: March 2016 eyed as Fed aborts lift off
Forecasts for an interest rate rise in the US drifted out further after the Federal Reserve (Fed) decided against kick-starting a cycle of rate hikes blaming global economic and inflationary pressures.
Unstructured Learning Time
- Stuttering China a cause for concern for the Fed
- Low inflation providing time for the Fed to pause for thought
- Is March 2016 now a more likely lift-off date?
- Will continued loose monetary policy store up future issues?
Outside forces keep Fed at bay
Schroders Chief Economist Keith Wade pushed his forecasts for a first interest rate rise in the US out to March 2016 after the Fed chose to keep interest rates at record lows in its September meeting.
External factors tipped the balance with Fed chair Janet Yellen referencing China concerns during her press conference.
Lower commodity prices and a strong dollar are weighing on consumer prices, giving the US central bank more time to keep rates at close to zero.
The Fed is watching carefully for signs of a hard landing in China which would exacerbate deflationary pressure in the world economy.
Certainly these developments will keep inflation low in the near term, but we would still see domestic price pressure building through the labour market.
No hard landing, but no clear pick-up for China.
The unemployment rate has now reached its equilibrium on most estimates and on current trends will fall further in the coming months.
It is true that wages have not accelerated as yet, but it is only likely to be a matter of time before we see wage costs picking up in our view.
China confidence eroding
As external factors are outweighing domestic it could be argued that the outlook for the Fed now depends on the outlook for China.
In our view China may get a boost from fiscal support in the coming months, but the underlying picture is one of an economy where growth is grinding lower.
The Fed could well wait beyond January before lift-off with March 2016 now the more likely date.
Our indicators suggest growth will decelerate toward 6% in 2016 as the economy faces structural headwinds from overcapacity. So no hard landing, but no clear pick-up.
Meanwhile, the economy will experience persistent deflationary pressure and markets will continue to debate the need for more policy action from the authorities, including a potential devaluation of the Chinese yuan (CNY).
Wage rises key
Against this backdrop we will need to see strong evidence of rising wages before the Fed will be confident that inflation is headed back to 2%.
This could take months: if we focus on the Employment Cost Index, seen as the best measure of wage pressure in the economy, we will need to wait for the next release at the end of October, and then probably the one after at the end of January, before being able to confidently identify the upswing in wage costs.
Storing up problems like it's the 1990s
Comparisons are being made with two years ago when the Fed decided not to taper following a tightening of financial market conditions.
Today is similar, but the current Fed could well wait beyond January before lift-off with March 2016 now the more likely date.
Is the Fed now behind the curve? The risk has to be that by delaying rate moves they will stoke future inflation and will then have to respond more aggressively.
However, the current environment is reminiscent of the late 1990s when the Fed cut rates in response to emerging market turmoil, more specifically the Russia default.
Like today, there were fears of deflation as external pressures outweighed domestic. The consequence was that US policy was kept loose; however in the Fed’s defence this did not result in a sharp pick-up in inflation.
Instead the excess liquidity fed into financial markets as investors took increasing risks and ultimately stored up bigger problems for the banking system and the economy.
Lisa Hornby's View from the US
The number of hours spent analysing Thursday’s Federal Open Market Committee (FOMC) rate decision must have set some kind of record.
Ultimately, the Federal Reserve (Fed) decided to leave the Fed Funds rate unchanged at 0-0.25%, citing recent global developments and their potential impact on inflation.
The FOMC also published an update to their infamous “dot plot”, that is each member’s individual projections of where the Fed Funds rate will be for the foreseeable future.
The market is still reflecting a much more benign outlook for policy rates than both the Fed and we are expecting.
The median rate expectation for year-end 2015 through 2017 moved down by approximately one hike per year, with the biggest surprise being that one FOMC member sees the Fed cutting policy rates to below zero and leaving them there until the end of 2016.
The FOMC now expects rates to be at 0.375% at year-end, 1.375% by the end of 2016 and 2.625% by the end of 2017.
These forecast policy changes were done in the context of growth expectations being revised higher for the year and unemployment rate expectations being revised lower. Headline inflation expectations were revised down for the foreseeable future.
US market response subdued
The US market reaction immediately following the statement was relatively muted.
Initially, equity markets moved modestly higher, while 10-year Treasury yields fell towards 2.2% and front end Treasury bonds outperformed longer term Treasury bonds.
The Fed Funds market is now pricing in a 25% chance of a rate hike at the 28 October meeting.
Going into the statement, the market was pricing in a 32% probability of a rate increase in September, as well as an extremely gradual and atypical hiking cycle, with just under three hikes priced into the market through December 2016.
To put that into context, over the past three hiking cycles, the Fed has averaged approximately 17 basis points of rate increases per month (or one hike every Fed meeting).
However, even with the Fed’s revised projections, the market is still reflecting a much more benign outlook for policy rates than both the Fed and we are expecting.
All in all, the Fed’s economic outlook remains relatively stable and positive. However, it is clear that international developments will dominate Fed policy in the near-term.