The surprisingly dovish March Federal Open Market Committee (FOMC) communications — the combination of the FOMC statement, Chair Janet Yellen's press conference and the Statement of Economic Projections — led to a large equity market rally and lower bond yields March 18, driven by the short end of the yield curve.
Though the market was fixated on the change to the Fed's forward guidance in the form of the removal of the “patient” language, this change was widely anticipated. What was not was a significant update to the Fed's viewpoints on the critical pillars of its dual mandate: jobs and inflation.
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In a nutshell, the Fed indicated it now sees “more slack” in the labor market and “less inflation” rebound in the economy. By dropping its estimate for the long-term unemployment rate from the previous level of 5.35% to 5.10%, the Fed was indicating that it saw more room for unemployment rates to fall, and therefore more slack in the labor market. What's more, this change implied that the improvement in the labor markets could continue to run apace without the risk of accelerating inflation.
RETURN OF INFLATION
On the inflation front, the Fed now expects the return of inflation toward its 2% target to take even longer than it had previously indicated. A slower return of inflation implies a slower pace of interest rate increases.
Capping off these changes, the policy implications of a slower pace of normalization were reinforced in the “FOMC participants' assessments of appropriate monetary policy,” otherwise known as the “dots plot.” These showed significant reductions across the forecast horizon for the federal funds rate — of 50, 62.5 and 50 basis points for year-end 2015, 2016 and 2017, respectively — while longer-run estimates were unchanged. Lowering the estimates for the funds rate is entirely consistent with expectations of more labor market slack (and hence less inflationary pressure from wages) and a longer period of normalization of inflation rates.
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These changes in the Fed's communications, likely more than the changes in the statement itself, did the most to alter market expectations, leading to lower shorter-maturity yields and higher prices on risky assets like stocks, corporate bonds and high-yield debt.
With this new guidance, the Fed went a long way toward closing the gap to market expectations. This is important in establishing the best possible environment so the first increase in interest rates does not lead to a significant negative market reaction. In that sense, last Wednesday's communications helped lay the groundwork for the first increase in interest rates and raised the likelihood that such an increase could occur without a significant impact on the financial markets.
The Fed's indicated pace of tightening now more closely aligns with investor expectations, though market prices still reflect significantly greater accommodation than was indicated by the Fed. Furthermore, the market's response to the March FOMC shows the potential for once again widening the gap between market expectations and Fed communications.
While that remains a future risk, the Fed clearly moved its guidance closer to market expectations, and in so doing reduced one of the risks in the market to the first tightening of policy.
NORMALIZATION
The March FOMC communications also underscore that the pace of normalization remains far more important to the outlook for the financial markets than the exact date of the first hike. We continue to think the Fed's first increase can occur sometime between June and September, but the March communications certainly shift the likelihood toward a slightly longer period of waiting before the first increase.
Finally, by easing the pace of normalization of interest rates in market expectations, the Fed indirectly addressed one of the head winds for the economic recovery resulting from higher short-term rates, namely the strength of the dollar. By reducing expectations for future rate hikes while at the same time actually lifting off interest rates, the Fed would go a long way toward easing the “one-way” bet viewpoint on the dollar.
The March FOMC updated the Fed's view of the economy as “more slack, less inflation,” and financial markets cheered the dovish implications. That also means, however, that wages and other forms of inflation will take on heightened market significance in the months ahead.
Jeffrey Rosenberg is chief investment strategist for fixed income at BlackRock Inc.
