United States: Fed delivers third rate hike in June despite subdued inflation
June 14, 2017
The Federal Reserve forged ahead with the third interest rate hike in as many quarters against a backdrop of a steadily declining unemployment rate and despite a string of soft inflation readings. At its 13-14 June meeting, the Federal Reserve’s Open Market Committee (FOMC) announced its decision to raise the target for the federal funds rate from a range of between 0.75% and 1.00% to between 1.00% and 1.25%. Although the decision was expected by most analysts in our panel, the hawkish tone struck by officials came as a surprise to some, who had expected the Fed to react more strongly to the slowdown in inflation.
The FOMC showcased a surprising degree of confidence in its inflation outlook. In the statement that followed the meeting, the Central Bank did acknowledge the recent succession of disappointing inflation readings, but it continued to describe inflation as running only somewhat below the Fed’s target. This hawkish tone was further hammered home when Chair Janet Yellen noted in the post-meeting press conference that ”it’s important not to overreact to a few readings and data on inflation can be noisy,” arguing one-off price factors had been largely at play in recent data. In line with this, the quarterly FOMC forecasts for PCE inflation were lowered to 1.6% for 2017 (March’s forecasts: 1.9%) but were left unchanged for 2018, suggesting a successful return to the 2.0% target next year.
The Federal Reserve also saw a strong labor market more than offsetting the recent weakness in inflation. Yellen said at the press conference that a wide variety of data was pointing to labor market tightness, including a steadily declining unemployment rate and worker shortages in some parts of the country. The Committee’s forecast for this year’s unemployment rate was lowered from 4.5% in March to 4.3%, while the long-run forecast also inched down to 4.6% (March report: 4.7%). The Fed, eager to steer clear of risks associated with labor market overheating, saw this as justification enough to gradually continue reducing monetary accommodation.
The Committee also continued to push ahead with its plan to start unwinding its USD 4.5 trillion balance sheet. The FOMC statement included the first operational details about the balance sheet normalization, which could start later this year “provided that the economy evolves broadly as anticipated.” Among the details, most conspicuous were the caps for the maximum roll-off for Treasury and Agency MBS securities. The Fed plans to initially reduce USD 10.0 billion of Treasuries and mortgages bonds a month for three months. It is then expected to raise the pace by another USD 10.0 billion every three months, until reaching USD 50.0 billion a month.
The FOMC’s hawkish tone, its emphasis on preventing excessive labor market overheating and a cautious approach to unwinding the balance sheet were all perceived as good news by the markets. The U.S. dollar strengthened and Treasury yields for multiple maturities trended higher shortly after the announcement. The FOMC’s ‘dot plot’—which charts Fed members’ expectations for future policy rates—was also largely unchanged in light of the Fed’s hawkish forward-looking guidance. Accordingly, the median dot continues to project three rate hikes both this year and next.
Author: David Ampudia, Economist