Fed Strikes a Resounding Note of Confidence

Bryan Perry
Posted: Mar 20, 2017 4:33 PM

The writing was on the wall and the Fed did not disappoint last Wednesday, March 15, when the Federal Open Market Committee (FOMC) stayed true to its preemptive rhetoric by bumping up its target range for the fed funds rate by 25 basis points from 0.75% to 1.00%.

The decision, as outlined in the Fed’s post-meeting policy statement, contained some upgraded views, as it certainly should have considering that the policy rate was increased. In particular, the Fed noted that business fixed investment has firmed somewhat and that inflation will stabilize around 2% over the medium term.

More importantly, the Fed stated that monetary policy should support some further strengthening in labor market conditions and a sustained return to 2% inflation. In addition, the committee expressed expectations that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate. The thrust of the directive is that the committee sees economic conditions improving and that it is more confident in inflation returning to, and being sustained at, the longer-run target of 2%.

At the same time, the Fed was careful in maintaining its median projections for the change in real gross domestic product (GDP), the unemployment rate and personal consumption expenditure (PCE) inflation. That supports the view that the committee is not speculating on the impact of fiscal stimulus from Trump initiatives without knowing any details and the timing of passing a fiscal stimulus package. The Fed has cried wolf once too often and is wise not to speculate on future stimulus in the form of tax reform, repatriation of capital, budget cuts and deregulation.

As such, the Fed’s median federal funds rate projections for 2017 and 2018 were left unchanged at 1.4% and 2.1%. It was bumped up slightly for 2019 from 2.9% to 3.0%, while the longer-run projection was unchanged at 3.0%. The market can live with a 3.0% fed funds rate, as it would signal a pretty healthy economy supported by strong wage growth.

Separately, Fed Chair Yellen emphasized that the fed funds rate target is the committee’s key policy tool. That statement creates an impression for market participants that the Fed isn’t in a hurry to reduce its balance sheet. That single impression sparked a surprisingly significant rally in the long end of the curve following the FOMC announcement. The 10-year bond saw its yield drop by 10 basis points to 2.50% in reaction as short-covering activity is probably aiding the move. That drop in the long end of the yield curve, as well as profit taking in the dollar, appeared to fuel equity markets to the upside as investors liked what they heard.

The major takeaway of this Fed meeting is that the market largely got its Goldilocks outcome in the form of a rate hike that acknowledges the improvement toward the Fed’s objectives, a dot-plot sticking with a projection for only three rate hikes this year and a reiteration that the committee still thinks a gradual path of normalization in the fed funds rate will be warranted for the right economic reasons. The understanding that the Fed doesn’t seem to be in a hurry to reduce its balance sheet was a cherry on the sundae.

Even better, the stock market acted in a more grown-up manner than in times past, when good news crossed the tape to spur a 300-point rally for the Dow only to see a hangover sell-off that followed the next few days thereafter. Yes, the major averages lifted higher, but the move was constructive and not euphoric. After all, the cost of money just went up and rising interest rates even off of such low levels can prove to be a headwind, if just nominal. But all in all, the Fed is exhibiting a kind of confidence not seen before.

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In case you missed it, I encourage you to read my e-letter from last week about what higher wages and a border tax can do for the U.S. economy.

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