Fed Watch: A hike, but a focus on inflation

06-14-2017

The Federal Open Market Committee (FOMC) delivered on near unanimous expectations of an incremental 25 basis-point tightening in its target federal funds rate today, raising it to a range of 1% to 1.25%. More importantly, the Fed appeared to acknowledge that the current unemployment rate below the perceived level of full employment coupled with inflation declining below its 2% target generates uncertainty for its policy plans. Although the policymakers did not go so far as to sharply lower their projections via the dot-plot, they did revise down median projections for inflation this year and lowered the median unemployment rate projection for the next three years and in the long run. Thus, they are acknowledging that the theoretical tradeoff between inflation and low unemployment has been, and perhaps will remain, muted. In addition, they indicated their heightened focus on inflation going forward, while dropping long-standing references to monitoring global and financial developments in their policy statement.

Today’s FOMC meeting took place after this morning’s release of CPI, which fell below expectations for the third consecutive month and showed that headline and core inflation are each below the Fed’s 2% target on a year-over-year basis. Treasury yields declined sharply across the curve following the CPI release, as well as disappointing retail sales data. The release of the FOMC statement at 2 p.m. had a modest countervailing impact, only partially diminishing the decline in yields on the day. In other words, the Fed and the markets are each apt to stay highly focused on the disappointing performance of inflation. If inflation remains below 2%, the Fed will react by softening its tightening plans and perhaps not reach the planned 3% level at the end of this tightening cycle. Based on a 10-year Treasury yield of about 2.1%, the market is already betting on such an outcome. Conversely, if inflation rebounds, expect the Fed to march on and Treasury market yields to rise from here.

The Fed provided more detail on the planned balance sheet reduction that will be accomplished through reducing the amount of reinvestments of maturing Treasury and mortgage-backed securities held in the Fed’s portfolio. The very gradual pace of balance sheet reduction described today complied with market expectations. In addition, the Fed reiterated it expects the reduction in asset holdings to begin this year, but they did not state the exact date.