Initial market (and Finance Twitter) reaction to the FOMC decision and subsequent press conference last Thursday seemed pretty unequivocal – this was a dovish hold. The one combination that was likely to lead to the most investor pain. A hawkish hold, or even a hike would have been preferred. But I am once again left scratching my head a bit, because I still think the FOMC were pretty darn close to hiking at this meeting. And I continue to think that they will hike in December. So was it really a dovish hold??
Here is the case for the doves:
- Inflation outlook revised down a little
- Median rate expectations over coming years (and in the long-run) revised down a little
- Long-run unemployment (equilibrium) rate revised down a little
- Two more FOMC members pushing their first hike to 2016 or beyond
- One member (very likely Kocherlakota) arguing for negative rates!
- Yellen highlighting the impact of the dollar, lower energy prices and weaker global demand as factors likely to restrain US growth and inflation somewhat.
- Yellen noting that the FOMC’s attention had been caught by the fall in breakeven inflation
- And lastly, there are those who think this decision just confirms that the Fed can never raise rates, and will be in an infinite loop that leaves them stuck at zero.
Here is the case for the hawks (by which I mean those who still think a hike is no the cards this year, and that the market is pricing too little beyond this year):
- GDP growth was revised up this year, due to the “notably stronger” H1 than the FOMC expected back in June.
- Unemployment rate projections were revised down a little.
- “Labour market showed further improvement” and the unemployment rate is already near the long-run equilibrium estimate.
- While she said that she preferred a broader measure of slack than the difference between the unemployment rate and the NAIRU, this was a long-held view and on those measures slack was also declining.
- Lower energy prices and stronger dollar were repeatedly described as being transitory factors. Indeed she described the moves since June as “small” and had not undermined their confidence in inflation moving back to 2%.
- Yellen several times said that while concerns about the international environment had increased, these were not sufficient to materially change their central outlook, or the risks around it.
- For the first time, Yellen said “an argument could be made for an increase in rates at this time”. It was discussed, but on balance decided to wait for a bit more evidence of labour market improvement to bolster expectations of inflation rising to 2%. [Note: this was a key point made several times by Yellen – she did not say that it was necessary for the global uncertainties to be completely resolved].
- Yellen said she “did not want to overplay the significance of [international and market] developments”
- Yellen said she wanted to emphasise that domestic developments had been strong.
- Yellen reiterated that they cannot wait until their objectives are met before raising rates, given the lags in monetary policy.
- Yellen made clear that October is a live meeting, and journalists have done a trial-run to make sure they can come to a special press conference if needed.
- 13 of 17 FOMC members still expect to raise rates this year.
My reading of these cases is as follows. It really was a close call as to whether they should start the normalisation process this month. But on balance they decided to wait just a little longer. And given expectations of a hike in September were reasonably high, the FOMC had to justify the reason for waiting a little longer. Those justifications did not sound to me like factors that kick the first rate hike into the long grass. Of course there will have been many on the FOMC who would have preferred going in December anyway (ie before the events of August).
The initial market reaction was to push back the timing of the first hike to 2016 and the dollar weakened. But in the days that have followed (and following remarks from Lockhart, Bullard and Williams) the curve has steepened and 10y is not far away from its pre-FOMC level. Likewise, the dollar is up against the euro and EM complex compared to pre-FOMC levels, but down a little against the yen. So maybe the market is coming around to the view that it wasn’t such a dovish hold after all. But EDZ5 and EDH6 are still around 6-7bp higher than pre-FOMC.
Interestingly US 2s10s (chart courtesy of @DavidTaggart on Twitter) is very little changed from pre-FOMC levels, after initially moving steeper and then flatter.
So I think there is scope to pay the front end on the expectation that December will become increasingly likely as the time for a first hike. But I also think we will see more term premia in the curve, so like to be short 10y as well.