Coming into today’s Fed meeting, there was little mystery about what it would do – nothing – but a lot of interest and a wide range of opinion about how it would communicate a decision to keep rates on hold. Speculation focused on three key communications:
- The “dot plot” – that is, the Federal Open Market Committee (FOMC) participants’ assessments of the appropriate policy rate over the coming years
- The balance of risk assessment
- The Summary of Economic Projections (SEP) for inflation, unemployment and NAIRU (non-accelerating inflation rate of unemployment)
The biggest surprise was that the median dots now indicate only two more rate hikes for 2016, down from the four hikes in 2016 projected in December. This had the effect of moving the Fed dot plot liftoff path for 2016 and 2017 closer to market pricing, but with the latter still well below the former.
As for balance of risk, whereas in January the Fed said that it was “closely monitoring” global developments and was “assessing” their implication, in the March statement the Fed has apparently finished assessing this risk and now concludes that “global economic and financial developments continue to pose risks.”
The SEP projections show somewhat less inflation in 2016 and slightly less inflation in 2017 than was projected in December, and the median estimate of NAIRU has been shifted down by one-tenth of a percentage point, to 4.8%.
Taken together, these adjustments to the dots, the balance of risk and the SEP inflation projections tilted this statement in a dovish direction. In particular, the currency markets noticed, and the U.S. dollar depreciated by more than 1% (according to the DXY index). Breakeven inflation also rebounded by 7 basis points (bps), indicating – correctly, we believe – that this is a Fed that is willing and in fact would like to let the economy run a little hot so long as inflation on the PCE basis remains below 2%. (PCE, or personal consumption expenditures, is the Fed’s preferred inflation measure.)
With the median dots shifting down by 50 bps in 2016, and with roughly four hikes priced in for 2017 and 2018, the dot plot indicates a Fed projection for the fed funds rate of 3% by year-end 2018, a projection within the range of 2% to 3% nominal predicted by PIMCO’s New Neutral thesis. Indeed, as of March 2016, at least five FOMC participants now see a “longer run” destination for the federal funds rate of 3%, and the median projection is for 3.25%. This is down from a longer run estimate of 4.25% in 2012 when the dots were first published.