We had two immediate reactions to what was unquestionably a dovish policy messaging takeaway from the Federal Reserve this afternoon, though perhaps not as dovish as it may seem as a first impression.
*** First, those dramatically lowered 2015 blue dots to a new clustered level of 0.625%, or two hikes in the federal funds range to 50bp – 75bp by year-end, were definitely the headline grabber, rather than anything explicitly said by Chair Janet Yellen. And importantly, with 2016 and 2017 marked down as well, they point to the shallow, flatter tightening trajectory we have been writing that the FOMC sees as perhaps the key characteristic of this rate cycle (SGH 3/16/15, “Fed: Towards a Rate Path Consensus”). ***
*** Second, the “cautious lean” towards September for a first rate hike now seems much more likely, while the odds have tipped solidly against the earlier June rate lift-off. Growth was marked down across the forecast, but Yellen went out of her way to stress “this is not a weak forecast” and indeed, directionally, our sense is that the outlook has not changed as much as its momentum has simply been moved back a quarter. That, to us, makes us think the Committee majority will probably still be reluctant to delay lift-off beyond September. ***
The Lower Longer Run Unemployment and Neutral Rate
We had expected both the longer run unemployment rate, or NAIRU, and the estimates for the neutral interest rate to be lowered at this meeting, though perhaps not by as much as they both were — even by the Committee hawks we might add. The implications are significant.
It means that even though the projected growth was marked down by 0.3% or so in all three years of the forecast, it looks like the Fed still sees that growth as strong enough to be running above the estimates of trend growth, for headline unemployment rate is still projected to be steadily falling through the 5% mark by the end of 2017.
But the lowered estimate of NAIRU means there will be almost no upward pressure on core inflation — none at all this year, with core inflation projected to be even lower this year, at no more than 1.3%-1.4% by year-end. Nor is it likely to be hitting its 2% target level before the end of 2017, if then.
The lower estimate of the neutral or equilibrium rate translates even more dramatically into the significantly lower and flatter projected path of interest rates across all three years of the forecast, not even getting to the 3.5% lowered neutral level after three years of rate hikes to remove the monetary accommodation.
It suggests to us the FOMC does not expect much if any in the way of broad-based wage growth this year that could nudge services inflation up enough to offset the downward pressures of the stronger dollar and sharply lower energy costs on goods inflation.
It is as though they are also reluctantly giving ground to the impact of the stronger dollar, but only in how long the “transitory” effect will be, not on the direction and sustainability of the recovery, and the — eventual — upward movement in inflation back to mandate consistent levels.
In other words, the FOMC is still firmly committed to its base case for eventual Phillips Curve linkages between unemployment and inflation to emerge in the data, albeit perhaps a little further down the road than previously estimated.
But the majority of Fed officials will we think fiercely fight back against what will be an increasingly entrenched market sense that the FOMC remains reluctant to raise rates, ever, and if it does, it is unlikely to be able to nudge those rates much above 2%, much less their lowered 3.5% neutral level.
A Convergence in the 2015 Dots
On that point, for instance, it is worth noting the dots were not only lower in 2015, but they were more compressed, reflecting more convergence in a Committee consensus on the likely timing to the first rate hike. Even the more hawkish FOMC members were marking their dots down while the uber-dovish colleagues edged theirs up a bit and higher across 2016 and 2017.
So while the lower dots do seem like a very dovish signal at first glance, the new contour of the dots is in fact less dovish than it might appear in that the Committee sees a much higher certainty a first rate hike is coming, and that there are likely to be two rate hikes by year-end.
And finally, we almost forgot to mention the removal of the patience language in the forward guidance. The guidance changes would have been the last decision the FOMC made after the discussion over the outlook and everyone had seen everyone else’s dot plots.
It looks to us they concluded it would be worth it to jettison the two-meeting patience language without sending any sort of policy signal even as they marked down the dots and lowered the odds on June. So for all the heated debate on the outside, it was a pretty undramatic farewell to the explicit guidance language.