Yet it chose not to raise interest rates. In normalising its monetary policy, didn't the Fed claim to take a 'data-dependent' approach, where its actions were to be dictated by US economic figures? Here are some factors that went into the Fed's very dovish decision.
1 – The main reason given for maintaining the status quo was "global economic and financial developments" and the related risks. The decline in global growth and tightening of credit conditions through widening spreads were mentioned several times during the press conference. But Yellen also noted that she was still influenced by disappointing data on inflation expectations. These expectations are reflected in TIPS (Treasury Inflation-Protected Securities), an indicator that is far from perfect because it is also affected by risk premiums and liquidity.
2 – A less official reason is that the Fed seems to be looking at the decisions of the other major central banks before acting. Yellen made a point of saying that the Fed was free to diverge from its foreign counterparts' monetary policies, but there is undoubtedly a link with the other central banks. Usually the other central banks take their cue from the Fed; now the reverse is true. The dollar's strength is being fed by the loose monetary policies of most other central banks. If the Fed had raised its key rates, it would have run the risk of fuelling the dollar rally even more – and further hurting the US economy.
3 – The Fed opted to be overly cautious rather than not cautious enough, despite the risk of finding itself behind the curve. It lowered its growth forecast from 2.4% to 2.2% and its inflation forecast from 1.6% to 1.2% for 2016, and this certainly played a part in its thinking. Curiously, the FOMC could not come to agreement on whether the risk to the growth outlook was balanced or had decreased. The explanation provided at the press conference was unclear, which points to a high degree of uncertainty within the committee. The Fed therefore decided to favour accommodation, even if that means raising rates more quickly later, rather than rigorously tightening policy and taking the risk of interfering with the US economy's current run.
4 – Finally, the Fed felt the need to reconcile the various expectations of all economic agents (the market, economists, and the Fed). Before the 16 March meeting, the market was not expecting rates to be raised in 2016; the consensus among economists was for two rate hikes; and FOMC members had announced four increases. Expectations among Fed governors have now dropped to two 25bp hikes, which implies a rate of 0.875% this year (see charts above). Yellen and her team deftly managed everyone's expectations.
Investors applauded the Fed's announcement. The dollar fell, providing a temporary boost to the US economy and exports; both short and long government bond yields declined further; and stock markets in emerging countries gained ground (see charts below). The Fed was thus able to keep its rates unchanged while providing assurances that this was not due to any weakness in the US economy – something that would have unnerved the markets.
- In our view, the 16 March FOMC meeting marks an important turning point in the Fed's strategy. In the coming months, the Fed's action will be guided more by how markets and economies around the world perform than by economic data at home.
- The Fed should, however, resume tightening its monetary policy if global growth stabilises and US data remain firm.
- This means that the dollar's softness, coming on the heels of the very dovish stance of the latest FOMC meeting, will be fleeting.