The U.S. Federal Reserve Holds Rates But Loses Credibility

Financial markets held their collective breath last Thursday as they waited to hear whether the U.S. Federal Reserve would raise its policy rate for the first time in more than nine years.

The Fed stayed its hand, as the market, but not most mainstream economists, had predicted. In its accompanying statement, the Fed cited global instability and a lack of inflationary pressures as its main justifications for continued monetary-policy caution.

Before we break down the Fed’s latest commentary, let’s recap why the Fed’s policy-rate changes matter to Canadian mortgage borrowers.

Had the Fed raised its policy rate, the U.S. dollar would most probably have surged higher, thereby lowering the cost to Americans of the exports we sell into U.S. markets while increasing the cost of the imports that we buy from our southern trading partners. The U.S. and Canadian economies are tightly linked, and Canadian provinces trade more with their neighbouring U.S. states than they do with their provincial counterparts. As such, changes in the U.S./Canadian exchange rate send ripples throughout our economy, creating winners and losers as the relative value of our currencies fluctuates.

In addition, while the Bank of Canada (BoC) has said that it will lag the Fed when it begins to tighten monetary policy, the BoC cannot decouple its monetary policy from Fed policy completely or indefinitely. Fed rate increases will hasten the arrival of the day when our own policy rate will rise, as distant as that prospect may still seem.

So it was with great interest (pun intended) that Canadians watched, and more importantly, listened to the Fed’s decision to hold rates steady based on its current assessment of the state of the U.S. and global economies. Here are my five key takeaways from the Fed’s latest commentary and analysis: 

1. The Fed acknowledged that it is now “monitoring developments abroad” when determining the appropriate path for the federal funds rate. This is significant because until recently the Fed had espoused an every-central-bank-for-itself approach that largely ignored the outside world, and because global uncertainties are likely to persist for many Fed meetings to come. The two questions that investors are now asking are: 1) Have global instability risks risen to the point where even an inwardly-focused Fed can no longer discount their potential impact when setting monetary policy?; and 2) Why is the Fed only now citing the slowdown in Chinese growth and falling commodity prices as reasons for caution when both have been in plain view for years?
2. At the Fed’s June meeting, Chair Yellen had stated that she would need to see “convincing evidence” that the Fed’s dual mandate of maximum employment and price stability was being met before raising the policy rate. At last week’s meeting, the Fed decided that overall inflation growth of 0.2%, as measured by the Consumer Price Index (CPI), outweighed substantial improvement in other U.S. headline economic data. Specifically, U.S. GDP growth had averaged 3% over the first half of 2015, the U.S. unemployment rate had dropped to 5.1% as of August, and U.S. core inflation growth (which strips out more volatile CPI inputs like food and energy) has hovered at a rate of 1.8% for most of this year, within reach of the Fed’s 2% target for overall inflation.
3. The Fed took a knife to most of its projections. It cut its outlook for both overall and core inflation over the next three years, and it now predicts that overall inflation will not hit its 2% target until 2018. The Fed reduced its GDP growth forecasts over the same period, and most interestingly, now predicts that U.S. GDP growth will slow from 2.3% in 2016, to 2.2% in 2017, and to 2.0% in 2018. The Fed also raised its GDP growth forecast for 2015 from 1.9% to 2.1% in acknowledgement of the improvement in growth seen in the first half of this year. Given that it is projecting only 2.1% growth for the full year, after seeing 3% growth in the first half, it is clear that the Fed doesn’t see the recent data improvement as a sign that the U.S. economy is reaching its long hoped-for ‘escape velocity’.
4. The Fed reduced its collective dot-plot projections, which chart each Fed member’s prediction of where the federal funds rate will be headed in the coming years. The median dot plot forecast for the Fed’s policy rate fell again, this time to 0.375% in 2015, to 1.375% in 2016, and to 2.625% in 2017. (These forecasts were each a quarter-point lower than the Fed’s most recent prior dot plot.) Interestingly, financial markets continue to price in a substantially lower policy rate over that entire period. Given that the Fed dot plots have overshot for years now, ironically, the market is actually doing a much better job at forecasting the Fed’s policy rate than are the dot plotters who have their hands on the interest-rate lever.
5. More broadly, while the Fed’s decision to leave its policy rate unchanged was expected, its dovish statements and forecasts were not, and both seemed to contradict the comments by Fed members leading up to this meeting. The Fed’s credibility continues to be undermined by its inconsistent, and often incorrect, assessment of market conditions and we are drawing closer to an emperor-has-no-clothes moment when markets remember that they, not the Fed, have the final say over prices. On that note, here is a link to an excellent recent Jim Grant interview where he explains why the Fed’s attempt to manipulate market outcomes has left us with valuations that are built on sand. (Warning: Watching this interview may turn you into a gold bug!)

The Fed has now set a very high bar for its first policy rate rise, and while its decision gives the market a short-term reprieve, it also heightens the fear that the Fed will wait too long before beginning to raise its policy rate, and then will have to raise more sharply than it would like in order to keep inflation under control. For example, Fed Chair Yellen cites the lack of wage inflation as part of her justification for maintaining ultra-loose monetary policy but she knows full well that labour costs are a lagging indicator. Many believe that the Fed will overshoot on its timing if it relies on rising labour costs as a key signal. It also doesn’t help that the Fed has a well-established track record of having kept rates too low for too long in the past.

So rates didn’t rise, but investor uncertainty did.

Five-year Government of Canada bond yields rose by one basis point last week, closing at 0.76% on Friday. Five-year fixed-rate mortgages are offered in the 2.49% to 2.59% range and five-year fixed-rate pre-approvals are available at rates as low as 2.64%.

Five-year variable-rate mortgages are available in the prime minus 0.65% to prime minus 0.75% range, depending on the size of your mortgage and the terms and conditions that are important to you.

The Bottom Line: The Fed’s decision to leave its policy rate unchanged and to adopt a more dovish policy stance may ultimately prove to be a cautionary be-careful-what-you-wish-for tale. The Fed’s inaction should keep both our fixed and variable-rate mortgages at or near today’s level for the foreseeable future. But it’s the more distant future that neither we nor the Fed can yet see that is making everyone just a little bit more nervous after last Thursday.