Updated: 07-25-2014The Federal Open Market Committee (FOMC), which included three new members, issued another formulaic policy directive in the wake of its June 17-18 meeting.  That appeared to be just fine with the capital markets, which didn't need nor want any sources of upset.

The gist of the directive, which did not contain any dissents, was that the FOMC continues to be encouraged by the improvement in the labor market and that it is comforted that longer-term inflation expectations remain stable.  Furthermore, improving economic activity induced the Fed to reduce its monthly asset purchases to $35 bln from $45 bln.  

Notwithstanding the report that CPI was up 2.1% year-over-year in May, the directive once again acknowledged that inflation "has been running below the Committee's longer-run objective."  Notably, Fed Chair Yellen said in her press conference that recent CPI data have been on the high side but that the data are "noisy."  In nearly the same breath, she provided the reminder that the Fed's longer-run inflation target is tied to PCE inflation (up 1.6% year-over-year at the last report). 

In conjunction with the June meeting, the FOMC updated its economic and fed funds rate projections.  The former shook out as expected, with the Fed lowering its central tendency growth projections for real GDP in 2014 and its unemployment rate forecast.  Its view of PCE inflation was changed only slightly with a bump to the high end of the projection provided at the time of the March meeting.

Strikingly, the Fed lowered its unemployment rate projections for 2015 and 2016 while leaving its real GDP growth and PCE inflation forecasts basically unchanged.

Fed Economic Projections (central tendencies as of June 2014)
  2014 2015 2016 Longer Run
Change in real GDP     2.1 to 2.3     3.0 to 3.2     2.5 to 3.0     2.1 to 2.3
March projection     2.8 to 3.0     3.0 to 3.2     2.5 to 3.0     2.2 to 2.3
Unemployment rate     6.0 to 6.1     5.4 to 5.7     5.1 to 5.5     5.2 to 5.5
March projection     6.1 to 6.3     5.6 to 5.9     5.2 to 5.6     5.2 to 5.6
PCE inflation     1.5 to 1.7     1.5 to 2.0     1.6 to 2.0     2.0
March projection     1.5 to 1.6     1.5 to 2.0     1.7 to 2.0     2.0
Core PCE inflation     1.5 to 1.6     1.6 to 2.0     1.7 to 2.0     --
March projection     1.4 to 1.6     1.7 to 2.0     1.8 to 2.0     --
Source: Federal Reserve

In terms of the fed funds rate projections, they continued to pan out mostly as expected.  That provided a measure of relief for those market participants who had started to think the stronger-than-expected CPI report might lead to some more hawkish thinking on the part of Fed officials.

The takeaway from the directive is that it is going to be more of the same policy accommodation for essentially the same time the market had envisioned prior to the June meeting, which is to say there was no basis to think a rate hike in the fed funds rate will occur before the second half of 2015.

Fed Chair Yellen warned in her press conference that incoming data could prove stronger than expected and potentially invite rate hikes that occur sooner and more rapidly than now envisioned.  In truth, though, that wasn't so much a warning as it was simply an obvious reminder.  She took pangs to add that incoming data could go the other way, too, and lead to rates staying lower for longer than now envisioned.

The real moment of truth from the press conference, though, came with a question that pressed Ms. Yellen about the committee's concerns over the low level of volatility and the risk that could pose for financial stability.   She answered carefully, saying the FOMC has no target for what the right level of volatility is, but to the extent that low volatility encourages added risk taking that poses a risk "later on," it would be a concern to her and the committee.

In a similar light, she was also asked whether the FOMC thought the stock market was overvalued.  She acknowledged that the FOMC looks at a number of valuation metrics, and while it is concerned about some of the trends in leveraged lending for instance, the FOMC still doesn't see equity valuations, broadly speaking, being outside the bounds of historical norms.

In short, Ms. Yellen had a chance to offer up her version of an "irrational exuberance" view.  She did not do that, however, and it was taken willfully by the stock market as a tacit blessing to keep buying stocks.  Fittingly, the major indices broke to new session highs after her remarks and the S&P 500 closed at a record high.

The peculiar correlation is that the Treasury market also rallied after the directive and in conjunction with the press conference.  The 10-yr note gained 16 ticks and saw its yield drop to 2.59%. Arguably, it was a move that flowed from the tempered inflation outlook or a move that reflected a belief that economic growth isn't going to live up to heightened expectations for the remainder of this year and into next year, meaning the fed funds rate will remain pinned at an extremely low level.

One shouldn't rush to too much judgment on a few hours of trading, especially when there were some bearish rumblings in both the stock and bond markets ahead of the FOMC meeting.  The ensuing rallies, therefore, could have been exacerbated by some short-covering activity.

Regardless, the prevailing message out of the Fed's June meeting is that it is more of the same for now on the policy front:  continued gradual tapering and a fed funds rate that isn't coming off the zero bound anytime soon.

--Patrick J. O'Hare, Briefing.com

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