Thursday, December 18, 2014

A "patient" FOMC

The Federal Open Market Committee (FOMC) today changed its forward guidance to indicate it can be patient in continuing to normalise monetary policy.  While it’s a shift in language they were at pains to insist that this is not a change in policy with the Committee seeing the change in language as consistent with its previous guidance and therefore not indicating an earlier than previously communicated increase in interest rates.

It was always going to be the case that at some point the Committee would be closer to rate hikes than the continued use of “considerable time” warranted.  Recent data has certainly been supportive of further progress towards policy normalisation being appropriate including jobs growth (payrolls), average hourly earnings and consumer spending.

The potential fly in the ointment for the Committee today was recent offshore developments including financial instability in Russia and sharply lower oil prices.  The Committee, rightly in my opinion, chose to stay focused on domestic growth and inflation considerations.

But in a nod to the lower oil prices the language around inflation was tweaked.  Out from the October statement was “the Committee judges that the likelihood of inflation running persistently below 2% has diminished somewhat since early this year” while included was “the Committee continues to monitor inflation developments closely”.

In the press conference Janet Yellen agreed with us (and, to be fair, the consensus view) that oil price falls will be a net positive for the US economy and that the inflation impact, while acknowledging the possibility of some spillover into core inflation, will prove to be transitory.  I agree, although I still think a significant spillover into core inflation may buy the Committee some time before hiking.  The Summary of Economic Projections shows lower than expected headline inflation in 2015 while core inflation is only slightly lower.

The statement also acknowledges further falls in inflation expectations, but point out that longer-term inflation expectations have remained stable.  Inflation expectations are important in determining the appropriate stance of monetary conditions but why expectations shift is just as important – they can also be due to factors that ultimately prove to be transitory.

The crux of the matter remains that underutilisation of labour resources continues to diminish and the Committee therefore expects inflation to rise gradually toward 2% as the labour market improves further.   Interest rate increases are coming.  I still think mid next year for the start of rate hikes with recent (domestic US) data suggesting risks around that timing are back to evenly balanced (rather than biased to later).