Steady As She Goes: Fed Holds Rates But Says Inflation Nearing Its Target

Inflation, the market’s favorite boogeyman, is closer to the Fed’s long-term goal but seems to be under control, the Fed said Wednesday as it kept its target rate unchanged in a range between 1.5 percent and 1.75 percent.

After spending about a year trying to solve the mystery of the missing inflation, the Fed pointed out in its post-meeting statement that inflation is finally near its objective of 2 percent. However, the Fed didn’t pepper its statement with any hawkish-sounding language that might have triggered more concern in the market.

“On a 12-month basis, both overall inflation and inflation for items other than food and energy have moved close to 2 percent...” the Fed said. “Inflation on a 12-month basis is expected to run near the Committee's symmetric 2 percent objective over the medium term.” Previously, the statement had said inflation was running below the target.

For the Fed, this could be read as a sign of progress, because a little inflation often means the economy is starting to run at a stronger pace. The 2 percent level isn’t necessarily so high that it would cause major concern, but might be high enough to keep investors from worrying so much about the economy’s overall health. The second part of the statement also could help reassure investors that the Fed doesn’t see much chance of the economy getting overheated in a way that might cause prices to spin out of control.

In a sense, then, this statement could be viewed in a “Goldilocks” kind of context. A little inflation is starting to show up but not enough to worry about, perhaps. If inflation is in control, that could mean the Fed faces less pressure to hike rates in the future, though the market still expects more rate increases this year.  The Fed basically pointed out that the economy is on path for 2 percent inflation and on a good track, and that the Fed will continue to be data-driven as it contemplates its next moves.

After the news, Fed funds futures projected a 95 percent chance of a hike by June and a 75 percent chance of another one by September, not much different than before the announcement. However, chances for a fourth hike by the end of the year dropped to around 45 percent, down from near 50 percent a little earlier this week. That’s probably the number investors might want to watch in the days and weeks ahead as the Fed’s statement gets digested and analyzed. Ultimately, if the Fed moves toward a fourth rate hike, it would probably raise peoples’ inflation radars and possibly drag on the stock market.

In the immediate wake of the Fed’s decision, stocks started to climb just a bit while yields in the interest rate complex remained about steady. Info tech jumped nearly 1 percent in the minutes after the decision, and financials eased. The market impact isn’t likely to be huge, because there really wasn’t anything too dramatic in the statement and the Fed was widely expected to hold the line at this meeting, according to Fed funds futures.

Other takeaways from today’s statement include the Fed removing a phrase it had used in its March statement, when it had said, “The economic outlook has strengthened in recent months.” It didn’t put in any new language to replace that, but simply removed it. However, the Fed said business fixed investment continues to grow strongly while household spending has moderated. The Fed also pointed to what it called “strong” job gains on average.

The Fed approached this month’s meeting facing a bit of a puzzle. On the one hand, it’s under pressure to keep inflation tame by raising interest rates, especially since the Personal Consumption Expenditures (PCE) price index  — which the Fed closely watches — recently hit 2 percent. That’s in line with what the Fed says is its long-term inflation target, though one month doesn’t necessarily mean a trend and core PCE prices excluding energy and food rose just 1.9 percent. Entering today, investors expected almost no chance of a rate hike at this meeting, but a nearly 95 percent chance of one by June and about a 75 percent chance for another by September.

Powell and company also might feel they need to reload their gun, so to speak. The Fed typically wants enough bullets in its chamber so that if a recession rears up, it can fire a few shots. In other words, the more the Fed raises rates before the next recession, the more it can lower rates to stimulate the economy if it becomes necessary. Even with the succession of hikes over the last two years, rates remain historically low, not giving the Fed a very long runway. While Powell told Congress earlier this year that he sees no signs of a pending recession, it’s been 10 years since the last one and that’s historically a long time to keep the economy growing, though past isn’t precedent.

On the other hand, if the Fed raises rates four times this year, as some investors expect judging from Fed funds futures which showed a 50-50 chance for that before today's meeting, it risks triggering a recession by flattening the yield curve. When shorter-term Treasury yields rise more than longer-term yields (as they’ve done lately during this tightening regime), the curve between them becomes flatter. Often in the past such flattening has come ahead of recessions. There is a bit of a chicken and an egg argument here, as Powell noted in remarks earlier this year, but the recent curve flattening did raise some eyebrows.

The gap between 2-year and 10-year yields stood at 46 basis points by midday Wednesday, relatively low historically. A narrowing yield curve conceivably could have the Fed worried about the potential for slower economic growth, which might be exacerbated by more rate hikes. It’s a conundrum.

Last time out, in March, Powell appeared to take umbrage at suggestions from the press that the Fed has “tolerated” or “allowed” inflation to hover below 2 percent. The situation now is a bit different, with PCE prices indicating 2 percent year-over-year inflation as of March, so that might help quiet some of the debate that’s raged over the last year about why inflation wasn’t showing up amid strong economic growth and falling unemployment. The question now is, if inflation is indeed here, how much can the Fed continue to tighten the screws without risking an economic slowdown, especially considering economies in Europe and Japan don’t seem to be out of the woods.

After the Fed hiked rates at its March meeting, stocks retreated, and haven’t closed above pre-meeting levels since. Fears of a more hawkish Fed and a possible fourth rate hike could be playing into the market’s tepid action, which came despite mostly exuberant Q1 earnings news.

FIGURE 1: TRADING SIDEWAYS This three-month chart of the S&P 500 (SPX) and Nasdaq (COMP, purple line) show that neither has made much progress since the late-March Fed rate hike. Markets didn’t react all that dramatically Wednesday as the Fed held rates steady. Data source: SPX Dow Jones Indices, Nasdaq. Image source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

Thanks, Europe

The dollar rallied into today’s Fed decision, possibly getting an injection of strength from growing concerns about European economic growth. Euro-area economic growth slowed to 0.4 percent in Q1,  the weakest in six quarters and down from 0.7 percent at the end of 2017. Concerns about Europe and how the cooling economy there might affect the European Central Bank’s (ECB) rate policy have recently helped push the benchmark German bund yield back down to levels that mark a widening divergence with rising U.S. 10-year yields. That trend bears watching, because if European yields remain much lower than yields in the U.S., it could factor into the Fed’s rate playbook moving forward. The dollar index is now up slightly year-to-date, though still down more than 6 percent from a year ago. One thing the stronger dollar might do is ease fears of inflation, since a strong dollar can make imported goods less expensive for U.S. consumers.

Financials Sputtering

Despite almost uniformly impressive earnings from the big banks, the financial sector limped into this week’s Fed meeting down more than 7 percent since the beginning of February, compared to around a 5 percent drop since then for the S&P 500 Index (SPX). It’s definitely a head-scratcher, because the sector’s weakness also comes as 10-year Treasury yields marched up to 3 percent for the first time in more than four years last week. They were at 2.97 percent immediately before the Fed decision. Typically, rising yields tend to help bank stocks. While you could look around and find lots of potential explanations for the lack of financial sector vigor, including inflation fears, rising mortgage rates, signs of weaker consumer spending, tariff concerns, and others, one thing does seem pretty clear: Financials and info tech helped set the positive tone last year but aren’t providing leadership in 2018. This leaves the market feeling a bit like a ship without a captain as no other sector really seems ready to step up to the wheel.

Powell Stays on Bench

Since taking over as Fed chair earlier this year, Jerome Powell has gone 0 for 2 (to borrow a baseball term) as far as market reaction to his remarks. Stocks sank following his testimony to Congress in late February and again after his press conference at the Fed’s March meeting. Today, with no press conference, Powell keeps his seat in the dugout, so to speak, and for that, investors might breathe a sigh of relief. The strange thing is, Powell arguably hasn’t said anything all that bearish in his past remarks, and definitely knows how to talk “Fed-speak” to both the media and Congress as well or better than his predecessors. The market’s failure to thrive in reaction to his words probably reflects this year’s psychology of investor caution and fear more than anything Powell has said or done.