Fed Update: Fed Leaves Rates Unchanged

1. Today [1] the Fed left interest rates unchanged. Two justifications were given. First, the Fed noted an increase in concerns about the strength of global demand, and the Federal Open Market Committee (FOMC) is now “monitoring developments abroad.” Hearing this will be no surprise to market participants. The increase in downside risk to global growth has been a clear contributor to a number of market developments since August, including heightened equity volatility, pressure on commodity prices (especially oil), and downward movements in emerging market (EM) currencies. Second, there is some added concern within the FOMC about inflation remaining below the Fed’s target. The Fed downgraded its 2016 inflation outlook slightly and added new language to the statement signaling continued focus on this part of the mandate. However, importantly, the Fed appears to be sticking with its view that a tightening labor market will lead to higher inflation over the next 2 years.

2. More generally, today’s decision reflected the Fed’s willingness to change the path of policy as a response to changes in the outlook. Being responsive to changes in the outlook is a key part of Chair Janet Yellen’s objective. While a hike in September may have been the FOMC’s expectation at the beginning of the summer, the emergence of new risks has clearly caused the Fed to reassess. We expect that being responsive to changes in the outlook and the risks around the outlook will remain a key focus for Yellen’s FOMC going forward. Of course, changes in outlook can go both ways, and a more stable risk outlook could be part of a justification for a hike in coming months, just as more risk around the outlook was part of the justification for a delay at today’s meeting.

3. The Fed still appears to be on track to raise rates this year. Yellen went out of her way to minimize the importance of today’s decision, and by doing so she discouraged investors from concluding that today’s decision was a signal that a bigger dovish pivot is underway. In particular, Yellen said forcefully that the Fed has not changed their medium-term outlook, which has been and will continue to be the basis of the argument to raise rates. Further, Yellen emphasized that the majority of the FOMC still thinks it will be appropriate to raise rates this year (while impossible to say for sure, it’s likely that the group that does not want to raise rates this year does not include Yellen).

4. The front end of the bond market had been pricing a low but positive probability of a hike today. Because the Fed did not raise rates, yields on the front part of the curve moved down, as would be expected. However, the moves have not been extreme, precisely because the market probability had been rather low. Long end yields are also lower, but because the Fed is not the main driver for long term yields—which are driven much more by growth, inflation and risk sentiment—the reaction in that part of the curve is more muted. Encouragingly, credit markets appear to be taking the Fed decision in stride, and ended the day close to unchanged.

5. Bottom line: Today’s decision has not changed our view of the Fed going forward. We continue to think the Fed will be responsive to changes in the outlook, and at the same time we think the Fed is on track to raise rates this year.