25 Sep 2015
The US central bank, the Fed, chose to leave rates on hold at 0-0.25% at their much anticipated September meeting. The case for raising rates or keeping them on hold was equally strong, however, markets were only pricing in a 33% probability of a rate rise.
The Fed’s messaging post the meeting seems to confuse investors at a time when certainty and confidence were required.
The US Fed voted 9-1 to keep rates on hold at 0-0.25%. Chairwoman Janet Yellen spoke after the meeting, citing the following:
1. Members were concerned regarding current deflationary pressures such as the higher US dollar, falling commodity prices and slowing Chinese growth.
2. Yellen, being a labour market junkie, referred to continuing issues with the headline unemployment rate indicating that it underestimated the slack in the economy because it does not measure those who are “underemployed” (those working less hours than they want, those who are in lower skilled jobs than their skills suggest).
3. The Committee was also concerned with the recent sharp increase in investment market volatility.
4. The Fed has increased its 2015 economic growth forecast from 1.8% at its June meeting to 2.15%, but lowered its 2016 and 2017 growth forecasts.
An October or December rate rise is still on the table, if the Fed remains committed to raising rates this year. However, comments by Yellen post the meeting appeared to be overly dovish, possibly indicating that their commitment to moving rates off zero this year is waning. The market is now pricing a 20% probability of a rate rise in October and a 50% probability in December.
We think the Fed erred in not raising rates at the meeting. Whilst the Fed's comments cited above are valid, the following also applies:
1. Headline inflation may be falling due to the rising US dollar and falling commodity prices, but core measures of inflation, and the Fed’s preferred measure of inflation (personal consumption expenditure), have been rising and now appear to be on steady trend higher.
2. We would agree there remains some slack in the US economy in terms of unemployment, but the headline unemployment rate is now below the Fed’s estimate of the natural rate of unemployment (where inflationary pressures begin to build), the number of new workers continues to increase at healthy levels, jobless claims are lower than before the GFC, and job vacancies are at all-time highs (indicating employer willingness to hire).
3. Investment market volatility should be irrelevant to the Fed – their job is not to manage markets. They have no mandate to do so.
4. The Fed actually increased their economic growth forecast for this year, but lowered their longer time forecasts. This indicates that they are moving their long run projection for the cash rate down towards market expectations, where there has been considerable divergence for some time.
Equity, bond and currency markets have already priced in one/two rate rises this year. What markets are unsure about is the trajectory (pace and level) of rate rises over the next three years, which is by far the more important issue.
We agree that the Fed’s previous forecasts for the pace and level of rate rises was too high (i.e. the market was right, which is usually the case). The Fed should raise rates at a slow and steady pace over the next three years with their ending level much lower than history suggests (3-3.5% versus 5-6%).
However, Yellen’s dovish comments post the meeting have caused some to speculate that the Fed won’t raise rates this year at all. The risk with not raising rates this year is that the Fed may have to move much quicker to raise rates at a later date. Quick and sharp rates rises are in no-one’s best interests.
The Fed needs to move at least once, if not twice, this year.