US Federal Reserve kept interest rates on-hold as expected

Today, the US Federal Open Market Committee kept the federal funds target rate unchanged at 0.00% to 0.25%. This was in-line with expectations, with only 1 of the 79 analysts surveyed expecting a 25bps rate hike. Janet Yellen stressed, in her press briefing, that even after the first rate hike, interest rates will still be extremely accommodative and that the pace of increases in US interest rates would be very gradual and well below the long-term average interest rate. The FOMC also indicated that it will maintain the existing policy of reinvesting principal payments from the Federal Reserve’s holdings of agency debt and agency MBS in agency MBS and of rolling over maturing Treasury securities at auction.

15 out of the 17 FOMC committee members still expect interest rates to start to rise this year. Four of the members expect rates to rise in three of the four remaining FOMC meetings in 2015, while another four expect two hikes and a further four anticipate only one hike. This is much more modest than what the FOMC committee members expected at the end of 2014. The remaining FOMC meetings for 2015 are 28/29 July, 16/17 September, 27/28 October and 15/16 December. The September and December meetings are scheduled to be accompanied by a press conference, as is the 15/16 March 2016 meeting. Hence most analysts assume the first rate hike will occur in September 2015, December 2015,or March 2016 (which is a rather simplistic way of guessing, but the Fed’s own comments appear to concur).

In making the decision the FOMC highlighted the following key points on the strength of the economy and the outlook for inflation.

  • Economic activity has been expanding moderately after having changed little during the first quarter.
  • On balance, a range of labour market indicators suggests that underutilisation of labour resources diminished somewhat.
  • Growth in household spending has been moderate and the housing sector has shown some improvement
  • Business fixed investment and net exports stayed soft.
  • Inflation continued to run below the Committee's longer-run objective
  • Market-based measures of inflation compensation remain low
  • Survey-based measures of longer-term inflation expectations have remained stable.

Inflation is anticipated to remain near its recent low level in the short term, but the Fed expects inflation to rise gradually toward 2% over the medium term as the labour market improves further and the transitory effects of earlier declines in energy and import prices dissipate.

Although the US economic performance weakened noticeably in the first few months of 2015, more recent economic data has reflected an improvement, especially retail sales, car sales and job growth. Nevertheless, the US GDP growth forecast for 2015 has been systematically revised lower. This is partly due to the strength of the Dollar. If the incoming data improves noticeably further in the next month or two then a hike in September would become likely. Clearly, the US labour market data remains the key economic indicator to watch. This includes the trend in US wages.

While the markets will not be surprised that the Fed kept rates unchanged, it might be surprised by the lack of clear direction in the FOMC statement relative to earlier statements, given the improvement in incoming economic data. Encouragingly, the Fed’s own rate projections are slowly (albeit very slowly) moving more in-line with market expectations.

Overall, we still expect the US FOMC to announce a rate increase before the end of 2015.

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