The U.S. Federal Reserve Morphs (Once Again) from Hawk to Dove

Dave Larock in Interest Rate UpdateMortgages and Finances

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The U.S. Federal Reserve adopted a very different tone last week.

After sounding increasingly bullish about the U.S. economy’s prospects in the lead up to its latest meeting, the Fed decided to change direction by offering a much more cautious assessment of the current state of the U.S. economy.

In the end, the latest U.S. employment data left far too much uncertainty about the sustainability of the U.S. labour-market’s hard-won momentum in the minds of the Fed’s members. And that heightened uncertainty was reflected in both the Fed’s press statement and its accompanying forecasts.

Here are the highlights from the Fed’s latest statement, with my comments added:

  • “… the pace of improvement in the labor market has slowed … job gains have diminished“. The latest non-farm payroll report, for May, showed a sharp slowdown in S. employment momentum and that alone had convinced markets that any Fed policy-rate rises would be delayed. Most of the experts I read believe that the Fed’s ability to stimulate employment growth is very limited, but it’s clear that the Fed isn’t going to tighten monetary policy until it is satisfied that the U.S. labour market is returning to health.
  • “Growth in household spending has strengthened.” While it would be an encouraging sign if the recent uptick in consumer spending had been a by-product of rising incomes, this increase has instead been fuelled by a corresponding rise in household borrowing, which only gives the economy a sort of short-term sugar high.

  • “ … the drag from net exports appears to have lessened”. S. exporters had enjoyed some much-needed short-term relief as the U.S. dollar sold off against other currencies. That said, with an estimated $10 trillion in negative yielding government debt from other nations outstanding, any policy-rate increase by the Fed in the current environment would send the U.S. dollar surging higher and quickly eliminate any semblance of a U.S. export-manufacturing rebound. This rebound has outsized importance for overall U.S. labour-market momentum because manufacturing jobs stimulate job growth in other parts of the economy.
  • “ … business fixed investment has been soft.” The Fed believes, just as the Bank of Canada does, that a rise in business investment will provide the surest signal that the U.S. economy is on a sustainable footing. But just as in Canada, S. businesses are sitting on record levels of cash and are more inclined to invest in share buy backs than in productivity enhancements and capacity expansion.
  • “Inflation has continued to run below the Committee's 2 percent longer-run objective … market-based measures of inflation compensation declined … [and] inflation is expected to remain low in the near term”. Low inflation rates allow the Fed to continue to focus its attention on the health of the S. labour market. If inflation were to take off, it could force the Fed to raise its policy rate, but even then, the Fed has indicated that it would tolerate above-target inflation over the short term if it felt that the broader economy still needed today’s ultra-accommodative rates. If you didn’t know it already, this is further evidence that this is not your father’s Fed.

In summary, the Fed is once again conceding that the current state of the U.S. economic recovery requires it to keep its monetary spigots fully open for the foreseeable future. While the Fed didn’t outwardly acknowledge this, it really can’t raise its policy rate at a time when the rest of the world’s largest economies are either cutting theirs or standing pat. There is simply too much risk that swimming against today’s prevailing global monetary-policy current would cause another spike in the U.S. dollar, reinvigorating a powerful headwind that could threaten the U.S. economy’s hard-won momentum by reducing its exports. Also, while the Fed did not make specific reference to Brexit concerns, that geopolitical uncertainty (among others) would also incline the Fed to keep dry what little powder it still has.     

The Fed’s more dovish tilt was also evident in its accompanying Summary of Economic Projections, which provides the latest forecasts of its members. Here is a summary of how the most recent projections differed from previous versions:

  • The Fed lowered its median dot-plot forecast for its policy rate from 1.875% down to 1.625% in 2017, and from 3.00% down to 2.375% in 2018 (Reminder: the dot-plot forecast charts where each Fed member thinks the federal funds rate will be in the coming years.) While this forecast remains well above market expectations, the downward revisions to the median forecasts confirm that the Fed’s members are becoming more cautious about future rate rises.
  • The Fed lowered its GDP growth forecasts for 2016 from 2.2% to 2.0% and for 2017 from 2.1% to 2.0%, and it left its 2018 forecast at 2%. So its GDP growth rate forecast is now flat for as far as Fed eyes can see.
  • The Fed now forecasts that its terminal rate, which is its expected peak for the Fed’s policy rate at the end of its current rate-hike cycle, will be 3.00%. This is a big reduction from its 4.25% forecast for the terminal rate only a few years ago.
  • The Fed has lowered its forecast for rate hikes in 2016 from four down to two. It eliminated one additional rate hike in 2017, and another one-and-a-half rate hikes in 2018. The Fed’s revised forecast is still wildly out of touch with the Fed futures market prices, which are determined by market participants. Fed futures prices have historically proven far more accurate than the Fed itself at predicting the path of the Fed funds rate, and these are now indicating that the Fed won’t raise until after February of next year. That said, the Fed’s downward revisions to its forecasts are still significant because they show that its members are becoming increasingly cautious about the S. economy’s prospects.

At her accompanying press conference, Fed Chair Yellen continued to emphasize “caution” and “uncertainty”, and she sounded decidedly less hawkish on the probability of imminent rate rises. Less than a month ago, she was warning that rate rises could well come “in the coming months”, whereas last week she said that “the evolution of the economy will warrant only gradual increases in the federal funds rate”, with no reference to any specific timetable. Back to square one we go.

Five-year Government of Canada bond yields rose one basis point last week, closing at 0.59% on Friday. Five-year fixed-rate mortgages are available in the 2.39% to 2.49% range, depending on the terms and conditions that are important to you, and five-year fixed-rate pre-approvals are offered at around 2.59%.

Five-year variable-rate mortgages are available in the prime minus 0.40% to prime minus 0.50% range, which translates into rates of 2.20% to 2.30% using today’s prime rate of 2.70%.

The Bottom Line: In less than a month, the Fed has gone from using hawkish language that was designed to prepare markets for at least one imminent rate hike, to using much more dovish language which suggests that any tightening in U.S. monetary policy has been moved to the back burner. This change in tone suggests that U.S. rates are far less likely to put pressure on Canadian mortgage rates, and that bolsters my belief that both our fixed and variable rates will remain at or near today’s levels for the foreseeable future.  

David Larock is an independent mortgage planner and industry insider specializing in helping clients purchase, refinance or renew their mortgages. David's posts appear weekly on this blog, Move Smartly, and on his own blog: Email Dave

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