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 US central bank softens its tone and will await more evidence of growth and inflation before hiking interest rates again.

When the US central bank, the Federal Reserve Bank (the Fed), announced the outcome of its interest rate meeting on Wednesday, the tone was surprisingly soft and the rhetoric rather different to earlier. The announcement was well received by the markets. Whereas central bank chair Janet Yellen previously focused on not wanting to be behind the curve with interest rate hikes, on Wednesday she signalled the Fed would be in no rush. What we heard was a central bank signalling it now wanted clear evidence of wage growth and rising inflation before firming its rhetoric. This was a clear shift in tone compared to the previous few quarters.

Good news for the markets
The surprisingly dovish rhetoric was good news for the markets, which broadly firmed following the statement.  The rhetoric means the market doesn’t need to fear aggressive rate hikes this year, which should support risk appetite and ease emerging market concerns for a while. It should also lend support to corporate bonds and senior bank debt.

Focus on global risks
The Fed chose to play down some of the rises that have actually occurred in wages and inflation and at the same time emphasised the low level of global growth and that significant risks still cloud the global outlook. While the Fed was more balanced in its description of the US domestic economy, it generally signalled deeper concern about the overall growth picture than we had anticipated. Although Yellen acknowledged that inflation and wages have been rising in recent months, she was apparently not convinced about the sustainability of these developments and wanted more robust evidence. All in all, the Fed adopted a surprisingly dovish tone, which was further underlined by central bank members revising down their projection for the number of rate hikes this year from four to two.
Another surprise was the Fed choosing not to revise up its inflation forecast despite the recent increase in inflation and despite the Fed expecting unemployment to remain below the long-term average for the next three years. In fact, no Fed member expected core inflation (core PCE) to rise above 2% before the end of 2018. While the Fed is now signalling two rate hikes this year, the market is pricing in just under one. The Fed has six more interest rate meetings left this year. What the Fed and Yellen are waiting on before deciding to hike is more wage growth and inflation. Economic data were weak over the winter, but have been improving as recession fears ease. But this is simply not enough for Yellen. She needs to see more evidence to be convinced. We expect two rate hikes from the Fed this year.

 

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