Heading into the June 15 Federal Reserve rate decision, we viewed a rate hike as off the table and the Fed obliged.
The Fed's statement was dovish and indicates that the Fed is prioritizing labor-market data over other growth measures.
While the Fed increased its qualitative assessment of consumer spending and exports, it downgraded its outlook for the job market. Other aspects of the report were clearly dovish – the number of members who expected just one rate increase this year increased to 6 from 1, the lone dissenter from April retracted her vote to raise rates, and future expectations were lowered. The statement also referenced a lowering of inflation expectations, a dovish development. Reflecting the softer environment, the number of rate hikes now expected in 2017 and 2018 was reduced from four per year to three per year and the terminal federal-funds rate was lowered to 3 percent from 3.3 percent.
The statement was silent on geopolitical risks or the effects of low interest rates globally. We are not overly surprised, but continue to believe that the Fed will take international economic and financial market conditions into account in future deliberations. While they might not directly admit it, we feel the June 23 "Brexit" vote, on whether Britain will leave the European Union, likely contributed to the decision to stand pat. Also, we think the Fed will not hike rates if we see an uptick in market volatility and falling equity prices.
While the Fed's median projection would indicate a total of seven hikes over the next two and a half years, we think it will likely be less than half that number. Since the global financial crisis the message has been clear: consistently lower interest rate expectations persist as the global economic recovery has failed to accelerate and disinflationary trends have remained in force. Importantly, we don't see the trends of the last five years reversing over the next five. The most important drivers of interest rates are growth and inflation, with a tertiary impact from quantitative easing. In 2013, we expected global growth to average 3.3 percent over the five years that would follow, and we cut that to just 2.6 percent in our most recent forecast. Likewise, our inflation forecast fell a full percentage point to 2.8 percent from 3.8 percent in 2013.
We remain moderately overweight risk. Investor focus has returned in recent months to when the Fed may raise rates. We wouldn't get too distracted by this debate. Even if the Fed chooses to raise rates this year, we expect the pace of rate increases in coming years to be very restrained. The Fed is keenly aware of downside risks as well as negative interest rate policies from the European Central Bank and the Bank of Japan. We think this caps the magnitude of potential Fed rate hikes, as unexpected dollar strength would tighten U.S. financial conditions and do the job of additional rate hikes. In addition, global growth momentum continues to disappoint – pushing other central banks into further easing actions.
The history of recent interest-rate cycles in the U.S. is that financial markets perform well in the early to mid part of the cycle, as long as the Fed doesn't negatively surprise investors. We think that remains the playbook for this cycle – so don't be too worried about Fed policy suffocating investor risk appetite.