After a volatile start to 2016 for global financial markets, the focus for the last week of January was on the first meeting of the Federal Open Market Committee (FOMC) this year and parsing the subsequent statement for insights on the Federal Reserve’s (Fed) current outlook on the economy, the fed funds rate and interest rates in general.
Following their December 2015 move to increase the fed funds rate by 25 basis points, the Fed had expressed confidence in the strength of the US economy and their inflation outlook, along with forecasting a “gradual” path for further rate increases. Since the initial calm acceptance of the first rate hike, substantial global tightening of financial conditions is threatening the budding economic growth envisioned by the Fed. As a result, the Fed has been forced to reintroduce the Committee’s international concerns from the September 2015 meeting, stating they will be “closely monitoring global economic and financial developments and assessing their implications for the labor market and inflation, and for the balance of risks to the outlook”.
Interestingly, the Fed moved comments on the US labor markets to the forefront of the January statement, prioritizing that “labor market conditions improved even as economic growth slowed late last year” (see interactive graph 1 below), highlighting strong job gains and “some additional decline in underutilization of labor resources”. These conditions are essential for their outlook for inflation to return towards their 2% target. On the other hand, the Fed clearly acknowledged that economic drivers of consumer and business spending were “moderate” versus “solid” in December. Similarly, they recognized that inflation would remain low in the near term due to further “declines in energy prices and in prices of non-energy imports” and that market-based measures of inflation compensation “declined further” as compared to “remain low” in December. Overall, the January FOMC statement sounded more dovish than the previous meeting.
Interactive graph 1: Change in labour market conditions
As the markets were digesting the FOMC statement, the Bank of Japan blindsided the markets on 28/01/16 by announcing the of implementation of negative interest rates in an effort to spur its economy. Joining central banks from Europe, Denmark, Sweden and Switzerland, the Bank of Japan will impose negative 0.1% rate on specified current account balances based on selective tiering. Financial markets rallied as more monetary policy stimulus is being applied.
In the short-end of the market, fed fund futures have consistently discounted the Fed’s ability to raise rates four times in 2016, as implied by the median rate in their December Summary of Economic Projections. As of the end of the week, Fed funds futures implied a very low probability of a Fed increase at the next FOMC meeting in March and introduced the possibility of only one hike for all of 2016.
Exhibit 1: The market is now (29/01/16) pricing in just one Fed rate hike in 2016
Source: Bloomberg, as of 29/01/16