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 Tuesday 18 July 2017

US Fed turns dovish - PM Bulletin



Last week Federal Reserve Chair Janet Yellen was in Washington where she presented the US central bank’s Semi-Annual Monetary Policy Report. She testified before both the House Financial Services Committee and the Senate Banking Committee and it is fair to say that the dovishness of her testimony caught most observers off guard. In particular, Dr Yellen noted: “Because the neutral rate is currently quite low by historical standards, the federal funds rate would not have to rise all that much further to get to a neutral policy stance.”

The fed funds rate currently trades between 1.00% and 1.25%. Ahead of last weeks’ testimony the general consensus was that the Federal Reserve would keep tightening until rates got up to 3% or thereabouts. This is what was implied by the FOMC’s very own “Dot Plot” in its quarterly Summary of Economic Projections. This suggested we could see another seven rate hikes of 25 basis points each to reach the neutral stance. So assuming the Fed hiked each and every quarter (which would suggest quite an aggressive tightening stance) they’d achieve 3% in March 2019. Dr Yellen seems to be telling us to forget this forecast. But the question now is what is the new “neutral rate” alluded to by her? Some have suggested it could be as low as 1.75%-2.0%. If so, this would imply we’re nearly there, which is very dovish indeed. But as she didn’t put a number on it we really don’t know.

Dr Yellen also said that the Fed was keeping a close eye on inflation. This is important as key inflation measures are still some way off the Fed’s 2% target and have been trending lower since January this year. This means inflation will continue to be an important factor in future rate decisions. Dr Yellen appears to be telling investors that the central bank remains data-dependent and will not blindly tighten monetary policy - certainly not if there’s any further deterioration in inflation or the employment situation. This is quite a turnaround from the hawkish outlook alluded to by various regional Fed presidents over the past two months. In fact, some analysts were convinced that the Fed was happy to let some air out of the stock market. Just a few weeks ago Dr Yellen warned that “asset valuations are somewhat rich if you use some traditional metrics like price earnings ratios".

Last week’s testimony could simply be an attempt to reassure investors that the US central bank will continue to back-stop them with pauses in the process of monetary tightening. In other words, it could simply be a countermeasure to a growing belief that the Fed was prepared to raise rates regardless of economic data weakness. But talking now about a slowdown in the rate of monetary tightening suggests the Fed is concerned about the outlook for US economic growth against background of tepid inflation. As Fed hawkishness has previously been taken as a vote of confidence in the US economy, their new-found dovishness shouldn’t be. The question now is how long it takes until investors see that problems persist, especially given the elevated levels of major US indices. Historically, this is not the starting point from which equities make strong gains.


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Posted by David Morrison

Category: PM Bulletin

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