US Interest Rates and the Fed
The Federal Reserve left monetary policy unchanged yesterday in what was a unanimous decision. The accompanying statement saw few meaningful changes to the one issued following the March announcement. The Fed still expects inflation to “stabilise around 2% over the medium term” while growth risks “appear roughly balanced”. There were slight nuances given that 1Q GDP was disappointing and the PCE deflator has softened recently, but the Fed suspect’s these developments will be “transitory”. In terms of the direction of policy the Fed reiterated that they believe economic conditions will “evolve in a manner that will warrant gradual increases in the federal funds rate”. Their last forecast update, published in March, showed that at that point in time the median Fed member’s expectation for the Fed funds rate was 1.4% for end-2017, 2.1% for 2018 before rising to 3% by end-2019. In terms of the outlook for policy we continue to favour just one 25bp hike this year rather than the two to three currently pencilled into the Fed’s FOMC member forecasts and the 40bp of tightening priced in by the OIS curve. The recent data flow has been somewhat softer than hoped, be it business surveys, GDP, employment growth or inflation. There is also a lack of clarity on the scale and timing of any fiscal stimulus brought about through President Donald Trump’s tax and spending plans. Consequently, there is scope for market disappointment that could lead the Fed to reappraise the situation. The statement also repeated that the Fed will maintain its “existing policy of reinvesting principal payments from its holdings” of debt securities and of “rolling over maturing Treasury securities at auction”. We will have to wait for the minutes to this meeting to see the actual discussion around this. Last time officials suggested that we could hear something about lowering the reinvestment rate this year. Such action would reduce demand from the biggest buyer and likely lead to higher longer dated bond yields and a steeper yield curve. However, given our more cautious prediction for Federal Reserve rate hikes we see scope for this policy change to slip into early 2018 – note the line that the wind down in the balance sheet won’t start “until normalization of the level of the federal funds rate is well under way”.