On Wednesday, markets went wild after the Federal Reserve’s latest policy statement. Stocks exploded, the US dollar tanked, gold surged, and bonds rallied.
The market seems to have reacted to three main things:
- Fed Chair Janet Yellen said in a press conference that though the Fed removed the word “patient” from its statement it would not become impatient about tightening monetary policy with interest rate hikes.
- The Fed noted that it sees additional slack in the labour market, and as a result lowered its central tendency for the unemployment rate to 5.0%-5.2% from 5.2%-5.5%.
- The Fed lowered its growth expectations for the US economy in 2015, 2016, and 2017.
But I was at the Fed meeting on Wednesday, and I think the market got it wrong.
The first point is what people were focused on ahead of the meeting — whether “patient” would be in or out of the Fed’s statement — and was the immediate thing investors looked at in the statement. Yellen’s clarification in her press conference that the removal of “patience” would not make the Fed “impatient” was seen as an obviously dovish turn from the Fed Chair.
But the second and third points are more interesting.
The Fed’s lower unemployment rate target isn’t out of reach
After the February jobs report, when the unemployment rate unexpectedly fell to 5.5%, some economists declared “full employment.” And what economists mean by “full employment” is that at 5.5%, the unemployment rate had breached the upper limit of the Fed’s central tendency for what the unemployment rate would be over the long run.
In economics-speak, this means that the unemployment rate had hit NAIRU, or the non-accelerating inflation rate of unemployment, or the unemployment rate below which inflation begins to take off.
Well, the Fed lowered this mark on Wednesday, meaning that it thinks there is more “slack” in the labour market than it had previously seen.
So this would appear, on the surface, to be clearly dovish.
But is 5.2% really out of reach for the unemployment rate by May, which is the last Jobs Report the Fed will look at before its June meeting?
Recent data would suggest not. In November, the unemployment rate was 5.8%. Three months later, the unemployment rate was 5.5%. And so if the labour market continues to beat expectations, there is reason to think — and precedent for — the labour market improving faster than the Fed expects.
The Fed clearly moved the goalposts on the labour market a bit on Wednesday, but the market reaction shows that it doesn’t expect the labour market meets those expectations in the coming months. Quite a bet.
The Fed might not wait for 3% GDP growth and a spike in inflation
The growth outlook is also something markets read as dovish. By taking its GDP outlook for 2015 down to 2.3%-2.7% from 2.6%-3.0%, the market sees the Fed losing faith in the economy, or at least losing faith that the economy will really start to “take off,” or as the Fed might prefer, “overheat.”
An alternative interpretation is that the Fed sees the economy we have now and thinks, “Well, this is what we’ve got.” According to the latest poll from Bloomberg, economists see the US economy expanding 2.2% in the first quarter of 2015, which is below the Fed’s growth expectations for this year but not by much.
Economists polled by Bloomberg think the US economy will grow 3% in 2015, better than the Fed thinks.
And so if the Fed sees economic growth right around where it expects for 2015, is it really going to be inclined to wait for the economy to outperform before raising interest rates?
The final piece here is inflation. The Fed dramatically reduced its inflation outlook for 2015, but Yellen again described the major things weighing on inflation — namely the decline in oil prices and, owing to the strong US dollar, export prices — as transitory. This means that the Fed thinks these factors will eventually go away.
Yellen also said that wage growth, which is something you’re going to need to see before inflation really comes roaring back, is not a precondition for interest rate hikes.
The Fed has stressed time and again that it will be “data dependent” in looking at its policy stance. Chair Yellen repeated this phrase again and again during her comments, though many in the market hear this and think it is just central bank double-talk and the Fed has no plans to ever raise interest rates. And yet 15 of 17 FOMC members indicated on Wednesday that they expect the Fed to raise rates this year.
All it takes is one meeting
The problem with the position that the Fed will never raise rates is that all it takes is one meeting for the picture to change, or for this stance to be wrong.
If the Fed really does plan to be data dependent — and I think it does — it will one day look at the data and decide it is time to raise interest rates.
And that day is way sooner to becoming a reality than the market expects.