What the Fed Did and Did Not Do

The main take away from the FOMC meeting is that the Federal Reserve is not the Bank of England. Hawkish comments by top BOE officials--not just Governor Carney--are encouraging investors to bring forward the beginning of a normalization of monetary policy and a tightening cycle, no matter how gradual. In contrast, the Federal Reserve stuck to its course, despite the recent pick up in inflation and the improvement in the labor market.

The idea that somehow the Federal Reserve was going to take its lead from the BOE was always a straw man. The economic challenges are different, and the institutional DNA is different. The thrust of a pro-growth bias often seems stronger in the US. Price pressures are moderating in the UK and have recently firmed in the US, yet it is the BOE that is concerned about pace that economic slack is being absorbed.

The Federal Reserve is nothing if not pragmatic. The proof of the pudding is in the eating, teaches the old proverb, taken to heart by Federal Reserve. Yellen gave voice to its "balanced approach." How far the Fed is from one objective shapes the extent it can tolerate an overshoot on another.

While the FOMC statement recognized the improvement in the labor market, it also stuck with its assessment that there is still significant under-utilization. Joblessness remains elevated. The Fed will continue to ease monetary conditions by buying $35 bln a month through the end of July, when the FOMC meets again. For the first time, the amount the Fed will purchase is lower than when QE3+ was first implemented.

There were no substantive surprises in the Fed statement, forecasts, or Yellen's press conference. The changes in the forecasts were concentrated in this year's projections. Growth was cut sharply to 2.1-2.3% from 2.8-3.0%, this is within what one would expect given the likely further downward revision to Q1 GDP. It left 2015 and 2016 forecasts unchanged (3.0-3.2% and 2.5-3.0% respectively).

Unemployment forecasts were shaved a little. This year was cut to 6.0-6.1% from 6.1-6.3%. Unemployment at the end of next year is expected to by 5.4-5.7%, down from 5.5-5.9% estimated in March and 5.1-5.5% in 2016, down from 5.2-5.6%.

Core PCE forecasts were nudged higher, and it continues to forecasts that this measure of inflation will not exceed 2%. This year's forecast was raised to 1.5-1.6% from 1.4-1.6%. The ranges for 2015 and 2016 were widened by reducing the lower end by 0.1%. Core PCE is expected to be 1.6%-2.0% in 2015 and 1.7%-2.0% in 2016.

The dot-plot of Fed funds for the end of 2015 edged up to 1.13% from 1.0% in March. The forecasts have the Fed funds at 2.5% at the end of 2016, up from 2.25%. Interestingly, the long-run equilibrium was lowered to 3.75% from 4.0%. We note, with the usual caveats about the light activity, that the implied yield of the December 2015 Fed funds futures contract is 77.5 bp up an insignificant 2 bp from where it closed after the March FOMC meeting. The December 2016 contract was unchanged from the March meeting, implying a yield of 1.825%. The December 2016 Eurodollar futures contract implies a 1.165% yield, which is about 10 bp lower than at the end of the March FOMC meeting.

Some observers suggest that the gap between the dot-plot and what the market is discounting means that investors are mis-pricing risk. Instead, consider that the relationship between the dot-plot and FOMC action. The dot plot exaggerates the role of the regional presidents who tend to have exaggerated views. Even now there is one that continues to forecast a rate hike this year. What the market appears to be discounting is not the dot-plot forecasts, but the signals from the leadership. There is every reason suspect that Fischer, who was confirmed last week as vice chairman, will be part of that centrist leadership of Yellen and Dudley.

Judging from the markets’ reaction, rallying bonds and stocks and taking the dollar lower, investors seemed surprised by lack of urgency by the Federal Reserve and the continued dovish posture. Alternatively, now past a potential risk event, investors recognize that even if the BOE has lost its bottle, global monetary conditions will remain very easy.

Between the Fed and BOJ, officials are still buying $100 bln of assets a month. New cheap (25 bp) four-year money will be available from the ECB starting in September. This financial environment is conducive to risk-taking and may help the MSCI Emerging Market Index to extend its 12% gains since mid-March. The decline in US yields seems to trump the fall in both Japanese imports and exports that had appeared to weigh on the yen.

The euro reached a six-day high just shy of $1.36, the upper end of the range the euro has settled in since the ECB meeting. Technically, it had looked like the euro was poised to push through the $1.35 level, but after several attempts, some shorts looked to have covered. In terms of asset performances, flows into Spanish and Italian bond and stock market appears to have slowed. If the positioning in the futures market is indicative of trend followers and momentum traders, the pain trade is a stronger euro and a move above $1.3620 now could spark a short squeeze.