US: Fed turns more dovish – FOMC review

Today’s signals from the Fed suggest that the central bank leaves June open as an option for lift-off in rates. However, the fact that the Fed voiced new concern about both inflation and global risks implies a dovish twist to the FOMC statement, although the central bank also upgraded its assessment of US economic growth. Friday’s employment cost index remains especially important for the timing of the first rate hike.

The Fed maintained its forward guidance, repeating that it can be “patient” in beginning to normalise monetary policy. The reference to patience indicates that the Fed is unlikely to begin raising rates for “at least the next couple of meetings,” according to the December FOMC minutes.

Thus, this leaves June open as an option for lift-off in rates, consistent with Fed speakers’ recent comments. If the Fed wants to signal the possibility of a rate increase in June, it will need to drop the “patient” phrase at the 17-18 March FOMC meeting.

However, the FOMC statement voiced new concern about inflation. Market-based measures of inflation compensation have “declined substantially in recent months,” the statement said but repeated that survey-based measures of longer-term inflation expectations have remained stable. While the FOMC expects inflation to “decline further in the near term” the committee still expects “inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate.”

Moreover, the Fed acknowledged global risks, saying that it will take into account information about “international developments” as it decides how long to keep rates at current levels. “International developments” were not mentioned in the December statement.

On the other hand, the FOMC remained confident about underlying growth and employment as it upgraded its assessment of the US economy. Thus, the statement said that economic activity has been expanding at a “solid pace”, versus December’s description of a “moderate pace”. It also said that the labour market has “improved further” and called recent job gains “strong”, an upgrade from last month’s “solid” job gains. Moreover, in new language the FOMC cited falling energy prices as boosting household purchasing power.

There were no dissents at today’s FOMC meeting. All three dissents at the December meeting — Dallas Fed President Fisher (hawk), Philly Fed President Plosser (hawk) and Minneapolis Fed President Kocherlakota (dove) — are non-voters this year and have been replaced by more moderate members. New voting members in 2015 are Chicago Fed President Evans (dove), Richmond Fed President Lacker (hawk), Atlanta Fed President Lockhart (dove), and San Francisco President Williams (dove), on balance producing a more dovish FOMC than last year.

Meeting minutes, which likely will have more meat than today’s statement, will be published 18 February.

Q4 ECI could be decisive for the Fed

As we read the Fed, the key reason it wants to normalise policy is that the strength of the economy is not consistent with zero interest rates. Thus, the GDP growth has exceeded 3% in five of the past six quarters (assuming our 3.2% Q4 GDP growth forecast is correct), and the economy is fast approaching full employment. At 5.6%, unemployment is now just shy of the level Fed officials expect to see in the long run, ranging from 5.2% to 5.5%.

Signs of wage pressures will be key to the timing of lift-off in rates. Thus, the Fed will need to see an acceleration in wages to be “reasonable confident” that the still-low inflation will return to target – a necessary precondition for initiating rate increases, according to the December FOMC minutes.

The Q4 employment cost index released on Friday will be especially important. Modest wage growth would further increase the risk of a later lift-off in rates than our June forecast. Accelerating wages, on the other hand, would suggest the economy is nearing full capacity. Recent indicators point to more upward wage pressures.