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03 16 2016 | by Victor Xing | Central Banks

March FOMC: cautiousness despite rising inflation

The March FOMC surprised on the dovish side as Chair Yellen sounded a note of caution on the sustainability of gains seen in core inflation, as well as likely “transitory factors” behind recent firming of price levels.  This was considerably more dovish than expected, as stronger CPI and PCE prints previously induced market participants to reduce their dovish risk positions.

Additionally, the slight decline in NAIRU projection was also perceived as dovish (further shift in the unemployment “goalpost”), even though the downward shift in SEP dots were largely expected following recent financial market volatility and the ensuing dovish speeches by a number of policymakers.

FOMC statement

The latest FOMC statement highlighted global macro risk factors as well as firmer inflation in recent months (source: the WSJ)

March FOMC

Summary of Economic Projections (SEP)

FOMC participants lowered their GDP projections (mostly 2016), reduced their longer run unemployment rate (NAIRU), as well as near-term inflation forecasts:

March FOMC
March SEP saw downward revisions to changes in real GDP, unemployment rate, PCE inflation and Core PCE inflation

The FOMC’s “dot plot” also turned “more gradual” relative to December (using the 5th lowest “dot” as a reference):

March FOMC
FOMC “dot plot” now indicates only two hikes in 2016

Chair Yellen’s press conference

Labor market conditions – stronger participation suggests scope for “further improvement” (more dovish than expected – especially on wage)

But there is still room for improvement. Involuntary part time employment remains somewhat elevated, and wage growth has yet to show a sustained pickup.

But the slow pace of wage growth, the fact that part-time employment for economic reasons, involuntary part time employment remains high, we have seen an upward move in labor force participation, which is heartening, and suggests that there was scope there for further improvement in the labor market. My guess is that those things influenced individuals who wrote down a slightly lower number for the longer run unemployment rate.

Inflation – on the sustainability of firming price levels (more dovish than expected)

Overall consumer price inflation as measured by the price index for personal consumption expenditures stepped up to one and a quarter percent the 12 months ending in January, as the sharp decline in energy prices around the end of 2014 dropped out of the year over year figures.

Core inflation which excludes energy and food prices has also picked up, although it remains to be seen if this firming will be sustained. In particular, at the earlier declines in energy prices and appreciation of the dollar could well continue to weigh on overall consumer prices.

Inflation expectations (slightly more dovish than expected):

The committee’s inflation outlook rests importantly on its judgment that longer run inflation expectations remain reasonably well anchored. However, the stability of longer run inflation expectations cannot be taken for granted.

Survey based measures of longer run inflation expectations are little changed on balance in recent months. Although some remain near historically low levels.

Market based measures of inflation compensation also remain low. Movements in these indicators reflect many factors, and therefore, may not provide an accurate reading on changes in the inflation expectations that are most relevant for wage and price setting.

Nonetheless, our statement continues to emphasize that in considering future policy decisions, we will carefully monitor actual and expected progress toward our inflation goal.

Easier financial conditions and foreign growth risks (largely on-expectations):

Although financial conditions have improved notably more recently, in addition, economic growth abroad appears to be running at a somewhat softer pace than previously expected.

The risk management argument of being cautious with policy normalization (largely on-expectations):

In addition, proceeding cautiously in removing policy accommodation at this time will allow us to verify that the labor market is continuing to strengthen, despite the risks from abroad. Such caution is appropriate, given the short-term interest rates are still near zero, which means that monetary policy has greater scope to respond to upside than to downside changes in the outlook.

On the shallow(er) rate path:

In other words, most committee participants now expect that achieving economic outcomes similar to those anticipated in December will likely require a somewhat lower path for policy interest rates than foreseen at that time.

Press conference Q&A

Chair Yellen’s concerns on inflation persists (more dovish than expected):

We did take note in this statement of the fact that inflation has picked up in recent months. I see some of that as having to do with unusually high inflation readings in categories that tend to be quite volatile, without very much significance for inflation over time.

So I’m wary, and haven’t yet concluded that we have seen any significant uptick that will be lasting in, for example, in core inflation. But we note, the committee notes as it did in December that we continue to monitor development trends, and developments closely, and that would include both the fact that recent inflation readings have been on the high side, and as I mentioned on the other side, that readings on measures of inflation compensation and some survey measures have been on the low side.

Foreign risks factors – China slowdown was “anticipated,” but weaker Japanese growth was “a surprise” (on-expectations over China, dovish on Japan)

Chinese growth hasn’t proven a great surprise. We have anticipated that it would slow over time, and it seems to be slowing as well. Japanese growth in the fourth quarter was negative. That was something of a surprise. And with respect to the Euro area, recent indicators suggest perhaps slightly weaker growth. So there’s been a number of emerging markets, as you know, where suffering under the weight of declines in oil prices that are affecting their economic activity. Our neighbors both to the north and south, Canada and Mexico, are feeling the impacts of lower oil prices on their growth.

Federal Reserve still lacks “convincing evidence” of stronger wage growth (more dovish than expected):

So, I must say I do see broad-based improvement in the labor market. And I’m somewhat surprised that we are not seeing more of a pickup in wage growth. But at least, and I have to say in anecdotal reports we do hear quite a number of reports of firms facing wage pressures, and even broad-based slightly faster increases in wages, wage increases that they are granting. But in the aggregate data, one doesn’t yet see any convincing evidence of a pickup in wage growth. It’s mainly isolated to certain sectors and occupations. So I do think consistent with the 2 percent inflation objective, that there is certainly scope for further increases in wages. The fact that we have not seen any broad-based pickup is one of the factors that suggest to me that there is continued slack in the labor market. But I would expect wage growth to move up some.

Negative interest rates have “mixed effects” in other countries – it is not something that the Federal Reserve is actively considering (perhaps only hawkish-sounding to former Minneapolis Fed President Kocherlakota, who had argued for negative interest rates in the U.S.)

We are prepared to respond if things transpire differently. But we are not spending time actively debating and considering things we could do for additional accommodation, and certainly not actively considering negative rates.

We are looking at the experience in other countries, and I guess I would judge they seem to have mixed effects, some positive and some negative things. But look, if we found ourselves in the unlikely situation where we needed to add accommodation, we have a range of tools. And we know from the things we did in the past that we have a number of options with respect to the maturity, for example, of our portfolio, with respect to asset purchases, or forward guidance, that remain available to us, that are tools we could turn to in the unlikely event that we need to add accommodation.

So negative rates is not something that we are actively considering.

Market reactions

Financial conditions eased considerably in reaction to the March FOMC.  Front-end and belly of the Treasury curve rallied 12 to 13 bps while the long-end mustered a token strengthening of 2 bps (5s30s bull steepened 11 bps).  Equities soared into the close, and WTI crude futures finished the day at 38.56 vs. 36.85 overnight.

It was a whipsaw session in the front-end rates market, as investors had initially priced in 1.6 rate hikes in 2016 following the above-consensus CPI release, and that figure had since declined to about just one hike for the rest of the year.

March FOMC
Fed funds futures rallied in response to the dovish FOMC surprise

Next article03 16 2016 | by Victor Xing | Economics

February CPI: the rise of core inflation