Citing “recent global economic and financial developments” that might restrain economic activity and put further downward pressure on inflation, the Federal Reserve (Fed) held interest rates flat at its September Federal Open Market Committee (FOMC) meeting. The decision was not shocking—polls of analysts suggested a split view on whether the Fed would raise rates or not. Nor should the decision have a significant impact on U.S. economic activity. However, the rationale behind the Fed’s decision, as enunciated in its statement, its economic forecasts and the Fed chair’s press conference, does suggest an even slower liftoff and more halting pattern of rate increases going forward, pointing to lower interest rates in the short run and an increased risk of economic overheating in the long run.

The rationale for inaction

Since its meeting in March of this year, the FOMC statement has suggested a liftoff in interest rates would come when the Fed had “…seen further improvement in the labor market” and was “reasonably confident that inflation would move back to its 2% objective in the medium term.” A decline in the unemployment rate from 5.5% in February to 5.1% in August and a slight rise in the core CPI inflation rate from 1.7% year-over-year (y/y) in February to 1.8% y/y in August would seem to have met these criteria and logically might have led the Fed to increase rates for the first time in nine years at its meeting this week. However, in its statement, the Fed noted, “recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” In addition, at her press conference, Fed chair Janet Yellen explicitly mentioned heightened concerns about growth in China and other emerging markets as well as the deflationary influence of some further appreciation in the dollar.

The Fed’s new forecasts, while boosting estimates of economic growth in 2015, reduce growth projections for 2016 and 2017. In addition, these forecasts, while assuming an unemployment rate of 5.0% for the fourth quarter of this year (down from a 5.3% projection in June), show only a very modest further drop to 4.8% by the end of 2016 and then hold at that level until the end of 2018. The forecasts also show only a slow acceleration in PCE (personal consumption expenditures) inflation from an energy-depressed 0.4% y/y in the fourth quarter of 2015 to 1.7% by the fourth quarter of 2016 and 2.0% by the fourth quarter of 2018. In its new projections for interest rates, the members of the FOMC now expect only one rate hike (of 0.25%) in 2015, compared to a previous expectation of two, although they still expect four rate hikes in 2016.

Monetary policy outlook

Although Yellen stressed, in answer to reporters’ questions, that the majority of the FOMC still expect a first rate hike in 2015, today’s decision casts considerable doubt on that forecast as well as the path of short-term interest rates thereafter.Under the old guidance, a falling unemployment rate was supposed to both trigger a start to rate hikes and maintain the Fed on a path of 25 basis point increases at roughly every second meeting.

The clear message of the Fed’s inaction today is that both the initiation and pace of monetary tightening will also depend on global growth and financial market stability, which the Fed has little power to influence and probably less to forecast.
The unemployment rate has come down at a very steady pace for the last six years, and analysts assuming a continuation of this trend could also assume a gradual path of Fed tightening. However, the clear message of the Fed’s inaction today is that both the initiation and pace of monetary tightening will also depend on global growth and financial market stability, which the Fed has little power to influence and probably less to forecast. This being the case, it is quite possible that some other event will occur between now and the end of the year to postpone a liftoff in rates until 2016, and Fed tightening could easily stall after it has started due to another temporary bout of market volatility. Indeed, the numerous events that have caused market volatility in recent years probably make it more likely than not that the Fed will not achieve the five rate hikes that it envisages between now and the end of 2016.



Investment implications

The Fed’s decision not to raise interest rates at its September meeting will likely have little effect on the U.S. economic outlook in the short run. Indeed, raising interest rates from very low levels might well have stimulated economic growth by boosting household interest income more than interest expense, by giving households and businesses a reason to borrow and invest ahead of further rate hikes and by reducing uncertainty. A rate rise would not have damaged the housing market, which is constrained by the unaffordability of down payments rather than mortgage payments. It is also an entirely open question as to whether it would have boosted the dollar—the last three times the Fed initiated a rate hike cycle, the dollar rose in anticipation of the first increase and then fell in the six months that followed. The U.S. economy appeared to be on a slow and steady upward path before the Fed meeting and remains on that path in its aftermath. It should be noted, however, that an even later liftoff in rates could delay reaching the tipping point at which rates begin to slow economic growth until well after aggregate demand has outstripped aggregate supply and thus produced higher inflation.

Regardless of economic impacts, the Fed’s rationale for its decision does suggest a slower general increase in interest rates, limiting bond market losses and potentially producing gains in some areas. It could also boost emerging market assets if investors feel less urgency to move money ahead of a more general flow of capital to the United States. Finally, it could limit U.S. equity market gains. While the Fed cited volatility as one of its reasons for not raising rates at this meeting, increased uncertainty about the Fed will likely increase volatility and thus hurt U.S. stocks even as the Fed itself, satisfied with U.S. progress, nevertheless waits on the world to change.

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