Article / 16 June 2016 at 0:38 GMT

Fed lowers rate projections but markets still don’t buy it

Managing Director / Technical Research Limited
New Zealand
  • It was no surprise to anyone that the Federal Reserve didn't move on rates
  • It neither confirmed market pricing nor stuck with its previous flight path for rates
  • Its statement gave no guidance as to the FOMC’s intentions in the months ahead
  • It did say inflation expectations had 'declined' recently rather than 'remained low'
  • Today’s May CPI reading will be of much interest to the FOMC

By Max McKegg

You have to go back to January 1994 to find the last time the US Federal Reserve caught markets napping with a change to the policy rate target. Every move since then has been signalled at least two weeks in advance by the federal funds futures market. And so with market pricing assigning a 0% chance of a move at Wednesday’s meeting it was a given the Fed would sit on its hands.
That meant any market movement would be caused by the post-meeting statement or the Summary of Economic Projections that accompanied it. In the event neither generated much excitement, although both the dollar and bond market yields declined a little in response to the projections. 

 Not quite taking off ... the Fed neither confirmed market pricing nor stuck with
its previous flight path for rates. Photo: iStock

Before the release, traders had been pondering whether the Fed would lean towards marking-to-market its dot plot for the fed funds rate or continue holding out the prospect of a handful of rate hikes this year. But in true central bank style, the Fed chose the middle ground, neither confirming market pricing nor sticking with its previous flight path for rates. 

The situation is illustrated in the chart below: policy rate projections by the 17 Federal Open Market Committee members are shown by the yellow dots; the green line representing the median. Clearly the median remains well above market pricing (purple line). The biggest change made came in the projection for 2018; a drop of 60 basis points to 2.4% (but note the outlier whose “dot” is actually under the market curve).

Fed dot plot
 Source: Bloomberg

The statement gave no guidance as to what the FOMC’s intentions are in the months ahead – no doubt because it hasn't got a clue. The Committee doesn’t seem too concerned about the global situation (including whether the UK will score an own goal in next week’s Brexit vote), instead concentrating on domestic matters. 

In particular, mention was made that inflation expectations had “declined” recently rather than “remained low” as in previous statements. Indeed, as this chart shows (click to enlarge) on that front things are certainly not moving in the right direction.

US 5yr/5yr
Source: St Louis Federal Reserve, Metastock

Fed Chair Janet Yellen has often pointed out, however, that the five year–five year forward break-even inflation rate derived from the spread between US Treasury bonds and TIPS seems to be driven by the bond yield and may not be a true reflection of the future inflation rate “economic agents” are assuming in their forward planning. 

It's all about that base

But what business and consumers do take into account is the inflation rate here and now. It’s timely then that later today we will get an inflation update via the May consumer price index. The annual rate of increase in the core measure is expected to tick up again after last month’s dip (see chart below). 

However, the headline rate will remain subdued for another couple of months until the impact of the mid-2015 oil-price decline drops out of the annual calculation. Once this “base effect” turns positive the headline will start to catch up with core, already running above 2%. 

But the FOMC’s inflation benchmark is the Personal Consumption Expenditures measure and, inconveniently for the Fed, CPI and PCE have diverged over the last year or so, mainly because the CPI has double the weighting of “housing shelter” (rent) costs. Thus core PCE languishes at 1.6% annually. 

But with the correlation factor between the two indices rising again, today’s CPI reading will be of much interest to the FOMC, as per this comment in the monetary policy statement: “In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal."

US inflation measures
 Source: Bank of New Zealand

The markets have had a veto over any policy rate changes by the FOMC and they continue to price in a lower trajectory for rates than that given in the Fed’s latest Summary of Economic Projections. Market pricing assigns a less than 10% chance of a July rate hike and only 40% of a move by year end. 

The odds may adjust a little after we see today’s CPI update, and traders would be well advised to follow the money. After all, over the last couple of years the market projections have been superior to the Fed’s and there’s no reason for that to change.

– Edited by Gayle Bryant

Max McKegg is managing director of Technical Research Limited. If you would like an email notice each time Max posts a trade or article then click here or post your comment below to engage with Saxo Bank's social trading platform.


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