Joining the Dots: Fed Keeps Rates Unchanged While Lowering “Dots”

The Federal Open Market Committee (FOMC) kept the fed funds rate unchanged from its 0-0.25% range, where it’s been since 2008. The decision was unanimous. The Fed did raise its assessment of the economy and labor market, which reinforces the view—shared by us—that the Fed will begin hiking rates in September, barring a significant change in the trajectory of the economy, jobs or inflation. It would be the first interest rate increase in almost 10 years.

A generally more positive statement

Some of the changes to the statement relative to the March meeting were as follows:

• Changed "growth slowed during the winter months" to "activity has been expanding moderately"
• Noted "some improvement" in housing but continued softness in business fixed investment and net exports; while deleting references to weak household spending and rising households' real incomes (courtesy of then-falling oil prices)
• Noted "energy prices appear to have stabilized"
• Eliminated reference to slowing "growth in output and employment…during the first quarter"

This was by no means a rave about the economy but the Fed does believe slack in the economy has been diminishing. Growth has been weak, but there’s a growing consensus (in which we reside) that the economy’s “potential” growth rate is lower than it’s been historically. Regardless of how sluggish the economy may feel, the math is such that slack diminishes when growth is above potential, which eventually leads to higher interest rates; but the cycle will likely be much slower this time.

Dots plot less steep

As it relates to the now-famous “dots plot,” showing how individual FOMC members see the likely path of rate hikes, the median expectation for year-end 2015 was unchanged at 0.625%—implying two quarter-point hikes before year-end. Notable though is that a few officials who were at 0.625% moved down to 0.375%, so the details of the forecast revisions were slightly dovish.

By year-end 2016, the FOMC now expects a fed funds rate of only 1.625%, which is down from its March forecast of 1.875%. The Committee also lowered its forecast for year-end 2017 to 2.875% from 3.125%. As it relates to the 2015 dot, it not only suggests an initial hike in September, but likely an additional quarter-point hike before year-end (possibly at the December meeting).

Due to the drop in the 2016 and 2017 dots, and as you can see in the chart below, the Fed’s assumptions about the path of rates hikes has been consistently “catching down” since last September to the market’s assumptions (based on the fed funds futures market).

Flatter dots

Fed estimate based on median Federal Open Market Committee (FOMC) projections. Market estimate based on Bloomberg Euro Dollar Synthetic Rate Forecast Analysis (EDSF). Source: Bloomberg, Federal Reserve.

CTPs generally healthier

In its statements, the Fed also publishes “central tendency projections” (CTPs) for the unemployment rate, inflation, and real gross domestic product (GDP). The CTP for the unemployment rate by the fourth quarter of 2015 is now 5.2-5.3%, up from 5.0-5.2% in March. By the fourth quarter of 2016, it’s expected to be 4.9-5.1% and by the fourth quarter of 2017 it’s expected to be 5.0-5.2%—both are unchanged from March.

The 2015 CTP for the rise in core personal consumption expenditures (PCE) is 1.3-1.4%, unchanged from March. But the lower end of the ranges for both 2016 and 2017 were increased by one-tenth, and now stand at 1.6-1.9% and 1.9-2.0%, respectively.

The 2015 CTP for real GDP growth is now 1.8-2.0%, down from 2.3-2.7% in March. The CTPs for 2016 and 2017 each moved up slightly to 2.4-2.7% from 2.3-2.7% in March, and to 2.1-2.5% from 2.0-2.4% in March, respectively.

Fed’s dual mandate

The fall in the dots path notwithstanding, the Fed has ample support from its dual mandate to begin telegraphing an initial rate hike. Remember, the Fed—unlike other global central banks—has an inflation mandate, but also an employment mandate. Although inflation remains tame and below the Fed’s 2% target, it has picked up from recent deflation territory. Job growth has been healthy for some time, but the Fed has had cover to keep rates at the zero bound due to anemic wage growth.

But most measures of wage growth have accelerated recently—including average hourly earnings (AHE), the employment cost index (ECI), employers’ cost of employee compensation (ECEC), and the “plans to raise worker compensation” component of the National Federation of Independent Business (NFIB) Small Business Optimism Index.

Soon but slow

During the press conference following the Fed meeting, Chairwoman Yellen emphasized that policy will remain highly accommodative even after the normalization process begins and said the importance of the initial hike should not be overstated. This transparency coupled with the lower dots plot suggests the Fed will move more slowly in this cycle than most of the recent interest rate hiking cycles. This cycle will not look like the one in the middle of the last decade when the Fed raised the fed funds rate 17 consecutive times. The high likelihood of a slower pace of tightening has potential implications for the stock market, as you can see in the chart below. Slow cycles have been much friendlier to stocks than fast cycles.

Slow beats fast

Fast cycle=one in which most of the hikes occurred in back-to-back FOMC (Federal Open Market Committee) meetings. Fast cycle dates: 11/20/67, 1/15/73, 9/26/80, 9/4/87, 2/4/94, 6/30/99, 6/30/04. Slow cycle dates: 4/25/46, 4/15/55, 9/12/58, 7/17/63, 8/31/77. Source: Ned Davis Research (NDR), Inc. (Further distribution prohibited without prior permission. Copyright 2015 © Ned Davis Research, Inc. All rights reserved.).

The risk for the stock market associated with this cycle is that longer-term rates, which have already moved up quite a bit from their recent lows, move up more aggressively. In fact, one surprise relative to market expectations was the limited change to the estimate of the longer-run neutral fed funds rate, which is a still-fairly high 3.5-3.75%. This is far above market-implied rates and if the Fed is right, and bond yields rise substantially (not our base case), it would be a risk for equities.