Fed Upgrades Economy, Concerned About Falling Inflation

Can be 'patient' on hiking rates
January 28, 2015 Updated: January 28, 2015

The Fed upgraded its assessment of the U.S. economy and labour market on Wednesday, but noted that falling inflation is a key concern and the central bank will remain “patient” in raising interest rates.

The Fed appears to be ready to start hiking rates this summer, as Fed chairwoman Janet Yellen explained back in December that “patient” was code for a timeframe of two policy meetings.

Stock markets fell, bonds rallied, and the U.S. dollar strengthened in reaction. The Canadian dollar dipped below US$0.80 for the first time since early 2009.

In its first meeting of 2015, the Federal Open Market Committee (FOMC) described the pace of economic growth as “solid” rather than “moderate,” which was the description used in its last statement published in mid-December. Moreover, it upgraded labour market conditions from “solid” to “strong.”

But another major change from the FOMC is acknowledging that inflation expectations have declined “substantially in recent months.” The Fed feels inflation will drop further in the near term, but will gradually rise toward the 2 percent target assuming that oil prices will rise from their current levels.

The Fed also gave more prominence to “international developments” as a factor that could influence a decision on interest rates. Given the ongoing economic weakness in Europe, China, and Canada, further strength in the greenback from a rate hike would make it more difficult for inflation to move closer to 2 percent.

Bond king Bill Gross of Janus Capital Group thinks the Fed will raise rates by 0.25 percent “sometime around June,” he said in an interview with CNBC shortly after the Fed statement was released.

Gross believes the Fed should send a signal given that the real economy is strong and that zero interest rates “distort capitalism,” since real interest rates remain negative. It would be a symbolic move on the Fed’s part.

With recent accommodative policy actions by the European Central Bank (announcing purchases of sovereign bonds) and Bank of Canada (cutting rates), the U.S. dollar has strengthened further this month. This effect has contributed to the falling U.S. inflation expectations, which are at lows last seen at the time of the Lehman bankruptcy in fall 2008.

And while the Bank of Canada has said the oil price decline was “unambiguously negative” for the Canadian economy, the Fed believes the effects are “transitory” and play an overall positive role by boosting household purchasing power.

The Bank of Canada in its monetary policy report last week suggested that the decline in oil prices from US$110 to US$60 over the next two years would raise U.S. GDP by about 1 percent by the end of 2016.

The Canadian economy is very much dependent on the U.S. economy continuing to outperform, as that is one of the factors the Bank of Canada expects will help lift GDP growth in Canada in the second half of 2015 and beyond.

There were no dissenting votes to the statement. The next Fed meeting, which concludes March 18, will provide new economic projections and Yellen will give a press conference.

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