As expected, the Federal Reserve left interest rates unchanged in the wake of weak April and May non-farm payrolls and modest inflation. The Fed’s short-term median projections remained the same at two hikes in 2016, although this projection reflected a more dovish tilt amid the higher level of uncertainty about employment and the economy. The number of FOMC members projecting only one increase this year increased from one member to six. Yellen also acknowledged in her press conference that the upcoming June 23 Brexit vote factored into the June rate decision, with respect to the potential impact of a UK exit from the European Union on the global economy and financial conditions. More broadly, she acknowledged that the FOMC considers global monetary policy to the extent that it affects the U.S. Dollar. Chair Yellen’s press conference comments indicate that the Fed may have adopted a third unvoiced mandate—global financial conditions.
The more significant changes reflected in the FOMC statement and Chair Yellen’s press conference related to longer-term projections for rate hikes and the longer run, or terminal, federal funds rate. The FOMC projections reflected an abrupt downward shift in the rate outlook, with one less rate increase in 2017, two fewer in 2018, and a lower longer run (terminal) rate of 3.0%, vs. 3.3% in the March projection. The terminal rate forecast was reduced in spite of unchanged longer-run median forecasts for GDP, unemployment and inflation. If inflation is expected to be 2%, the FOMC has adjusted downward its view of future real rates. Highly relevant was Chairman Yellen’s characterization of this terminal rate in her press conference as consistent with the “new normal,” in which aging demographics and falling productivity have reduced long-term economic growth expectations.
While the tone of the statement and projections was more dovish than March, Yellen insisted that every FOMC meeting is a live meeting, and that it is “not an impossibility” that the Fed could move in July. While the double negative raises doubt that the Fed would indeed move in July, we do believe that such a move is possible. Inflation is unfolding as the Fed has predicted; the Summary of Economic Projections revised inflation higher by 0.2% in 2016 to 1.4%. Chair Yellen downplayed the decline in longer term inflation expectations reflected in the University of Michigan Inflation Expectations consumer survey and the five-year forward breakeven inflation rate. Should employment indicators rebound (and atypically, the FOMC stated their conviction that labor markets “will strengthen”), and a Brexit “Remain” vote prevail, the Federal Reserve could still implement a July rate increase.
There are two interpretations to the weak May non-farm payroll report:
- The U.S. is in the mature phase of the recovery and nearing full employment; jobs remain open because employers cannot find workers to fill them at current wage levels.
- U.S. economic growth is falling and corporations are reducing hiring in anticipation of lower demand.
We believe the U.S. economy has entered a more mature phase of its recovery, and that increased wage inflation is confirming that fact. As Chair Yellen indicated, other employment reports remain strong. Initial claims data indicate that the weak non-farm payroll report is not supported by more layoffs. In this environment, the danger is that the Fed will fall behind the curve in controlling inflation. Should this be the case, the markets are facing a significant revision in the current low probability they assign to a July rate increase.