US Central Bank scales back rate-rise forecasts

US central bank’s rate-setting committee keeps interest rates unchanged, one dissenting voice

After increasing key interest rates for the first time in nearly a decade in December 2015, the Federal Open Market Committee (FOMC) kept the federal funds rate unchanged at its 16 March meeting. There was one dissenting voice in favour of an interest-rate hike. The statement was quite ambivalent. The Fed’s assessment that “… economic activity has been expanding at a moderate pace despite the global economic and financial developments of recent months” can be interpreted as an indication of robustness. At the same time, the Fed warned that “… global economic and financial developments continue to pose risks”. Similarly, the Fed states that “inflation picked up in recent months” while conceding that market-based inflation expectations remain low. This indicates that the Fed wants to keep all options open.

Fed sees only two instead of four rate hikes in 2016
The FOMC forecasts, published every quarter alongside the FOMC statement, remained nearly unchanged for economic growth, unemployment and core inflation. For headline inflation, however, the median inflation forecast was lowered from 1.6 percent in the December projection to 1.2 percent. What did change was the Fed’s own rate outlook, the so-called “dots” – a chart plotting FOMC members’ interest-rate expectations for the next few years. The median for the end of 2016 was lowered from 1.4 percent in December to 0.9 percent, for the end of 2017 from 2.4 percent to 1.9 percent. This implies just two rate hikes in 2016 compared with a previous forecast of four rate hikes.

We stick to our forecast of three rate hikes by end 2016. US employment, private consumption and housing investment continue to be robust and we see first signs of a recovery in manufacturing (March Empire State manufacturing survey, new orders, February manufacturing production and factory orders). Inflation is normalising – the February annual core inflation rate stood at 2.3 percent – and further strong economic data may sway the FOMC members’ opinion. At the same time, market expectations are very low with not even one full US interest-rate increase priced by the end of 2016 (see chart).

Chart: Fed fund rate expectations (“dots”) compared with market expectations

Source: U.S. Federal Reserve, Bloomberg, Vontobel Asset Management

The impact on markets
Everything else being equal, the lowering of the Fed’s “dots” from four to two interest-rate hikes in 2016 is supportive of equity and credit markets in the period ahead. The very gradual normalisation of US monetary policy is admittedly removing the probability of US-dollar strength in the near term, though the downside risk looks quite limited given the divergence of monetary policy between the Fed and other major central banks going forward.

Christophe Bernard – Chief Strategist – Vontobel