The FED hike of 25 bp the last week did not come as a surprise, as it had been carefully prepared in the earlier two weeks. However, the Janet Yellen’s press conference brought some surprises. To make simple, the Fed is clearly more dovish than some, could have anticipated.
The FED message
The first surprise came from the language used. The statement referred to core inflation, which is lower than headline inflation (2.2% versus 2.7%). Besides, the report focuses on the symmetrical character of the inflation target, which means that the Fed is prepared to tolerate inflation slightly above 2%, so as to prevent a market reaction if inflation were to exceed this threshold again in the foreseeable future, which is likely to happen.
Janet Yellen confirmed that normalisation of the balance sheet had been discussed during the meeting but that, as things stand, no decision was taken. She also said that a gradual tightening cycle was consistent with a pace of 2 to 4 rates hikes per year.
The second surprise is that the FOMC did not take into consideration any inflationary pressures brought by new potential fiscal policy as the tax border or an infrastructure investment program. The fact that nothing was mentioned about these risks means that somewhat the Central Bank does not believe that the new administration would be able to convince the Congress and to implement such policies or that the impact would be very limited.
The dollar issues
Another element not mentioned but in the mind of the Committee is the dollar. The prolonged period of extremely low U.S. interest rates has pushed borrowers to increase their exposure to the dollar massively for the past decade, – making them more vulnerable to the Fed’s policy decisions than ever before-. Non-bank companies and governments outside the U.S. had some $10.5 trillion in dollar-denominated debt outstanding, according to the Bank for International Settlements. That’s more than triple the level of September 2004, the last time the Fed was about this far into a cycle of rate increases.
What operating conclusions can we draw from all this?
The dovish stance is a priori good news for most asset markets. A more dovish Fed and the stable dollar are also relatively positive for emerging debt and equity markets, especially as Trump’s protectionist threat against these countries is not materialising (except for Mexico). As for emerging equity markets, in such an environment they would benefit from a performance fueled by a substantial discount (more than 10%) and international investors’ underexposure.
FED stability at risk
We should acknowledge that the analysis is based on the current composition of the FOMC. However, there will be three vacant positions this year, and potentially two next year with a likely change at the head when both Janet Yellen and Stanley Fischer’s terms expire. It means that President Trump will nominate the new FED member, – without consulting the Congress -. Another element completely ignored by the market. The most unpredictable U.S President on record will choose four on seven FOMC committee members of the most powerful monetary institution in the world.