The Fed maintains a commitment to keep rates steady for a long time and global stocks surge! Naturally, the expectation had been that it would hawk things up a bit more than it did -- and clearly equity investors were happy to be disappointed. The thing is, I don’t think we’ve seen the last of this sort of price action.
Based on Fed Futures, markets expect the Federal Reserve to start hiking rates by June next year. Something that Fed participants don’t seem especially eager to contradict -- only two of 17 think rates won’t go up sometime next year. What’s interesting is that the Fed participants themselves, who are obviously aware of market pricing, have quite an aggressive tightening cycle plotted. Most expect the Fed Funds rate to end 2015 at over 1 per cent, with over a third are looking for rates of over 1.5 per cent. On that basis we’re looking at a rate hike at nearly every meeting in the second-half of the year -- taking the Fed Chair’s guidance of no rate move in the first quarter.
To my mind, this is very unlikely to unfold. I suspect we’ll get one, maybe two rate hikes for the year max, although the way things stand now, there is a higher probability they don’t move at all.
It all comes down to the inflation outlook. The FOMC’s central forecast is that headline inflation will range between 1 and 1.6 per cent by the end of 2015, while core inflation will be between 1.5 per cent and 1.8 per cent. What’s interesting about that, is that these forecasts are already below the Fed target of 2 per cent. Remember that the Fed is of the view that it “will be appropriate to maintain the 0 to 1/4 per cent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October, especially if projected inflation continues to run below the Committee's 2 per cent longer-run goal.” That view did not change at this latest meeting or with the Fed’s new language of being ‘patient’.
To be honest, the Fed is all over the shop. It is being incredibly inconsistent by the looks. On the one hand, the Fed is trying to prepare the market for a hike, while noting that it’s data dependent and that if inflation runs below its objective it would change its mind. At the same time, it is forecasting inflation to run below the target.
What’s hard to see is inflation coming anywhere near the upper bound of those ranges given the surge in the US dollar and the collapse in crude prices. These are both very recent events and the transmission of both through the economy has barely even begun. The Fed Chair was right about one thing -- the drop in crude prices is one of the most important developments shaping the global economy -- although she a little blasé about how that would impact inflation.
The fact is it’s a huge disinflationary pulse. Crude has dropped off some 50 per cent in the space of six months -- and we’ve only seen a fraction of that flow through to the economy. It’s unlikely to be some short-lived transitory effect as Yellen believes. Petrol -- or gasoline -- prices are barely off 5 per cent so far, according the latest CPI figures. Clearly there is some way to go. More broadly, import prices are only down about 2 per cent or so over the year, notwithstanding the 50 per cent slump in crude and a 10 per cent spike in the US dollar. On current trends, headline inflation is more likely to range between 0.5 per cent and 1 per cent by mid next year, with core inflation somewhere between 1 and 1.5 per cent. The Fed isn’t going to hike with inflation outcomes like that.
It’s not that the Fed hasn’t hiked rates when core inflation was low. It tends not to, but it has. The last time was back in 1999. Then again, at that time the unemployment rate was only a little above 4 per cent, the economy was cruising along between 4.5 and 5 per cent, while the Nasdaq had just put on a lazy 40 per cent -- in one year. Closer to 90 per cent over two -- and it proceeded to spike another 70 per cent or so in the six months after the Fed’s hike! The US economy is strong, as is the bull market -- but not that strong. So the bar for inflation is markedly higher.
With that in mind and assuming the crude rout is sustained; I’m still of the view that lower US inflation will see rate hikes priced out. The Fed will become more dovish and equity markets will surge as a result.