Markets close tumultuous January on the up as US Fed keeps its cool

29 January 2016

As we wrote last week, it has become increasingly apparent that much of this January's market sell-off has been driven by fears that the US Federal Reserve (Fed) may have committed a policy error by raising rates in December and could potentially commit another by raising them again in March. It is, therefore, not surprising that the Fed's statement about the results of their January meeting was the most keenly awaited market news-item of the week.

The challenge for the Fed is that, while markets are enthralled by the Fed's monetary policy direction, the real underlying issue is arguably a lack of market confidence, which is what makes looser monetary conditions still such a necessity, despite a quite healthy economy. The Fed was therefore caught between the proverbial '˜rock and a hard place'. Markets wanted to hear from the Fed that, in light of the market turmoil since their first rate rise, they would no longer consider raising rates again in March. However, when they actually did something similar last September, markets still reacted negatively, because the Fed's hesitation served to spread fear that economic conditions may be worse than anticipated.

So, following a two-day meeting, the Fed issued a statement on Wednesday 27 January stating that, "the committee [FOMC] is closely monitoring global economic and financial developments and is assessing their implications for the labour market and inflation'.  Importantly, while the US economic fundamentals are still positive, the US economy is not experiencing the robust lift-off perhaps initially expected by the Fed.

The Fed currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labour market indicators will continue to strengthen. However, inflation is expected to remain low in the near term (in part because of the further declines in energy prices) but rise to 2% over the medium term, as what is described by the Fed as the transitory effects of declines in energy and import prices dissipate and the labour market strengthens.

As expected, markets gave a mixed reaction to the Fed's statement. In light of the current levels of uncertainty and volatility, some investors were keen for the Fed to be more definitive - and accommodative - in their policy and forward-look; i.e. to explicitly rule out any near or medium-term increases in the fed funds rate.  However, while the Fed must of course consider prevailing market conditions and financial developments, a policy based on these factors alone would indicate that short term market developments are effectively determining monetary [macroeconomic] policy. In our view, such an approach would give rise to even greater uncertainty and market turbulence, because it would essentially turn monetary policy into a self-fulfilling prophecy.  We think the Fed has struck the right balance in acknowledging global market conditions but continuing to steer monetary policy on the economic fundamentals.

Going forward, the Fed has suggested that the timing and size of any future adjustments to the target range for the federal funds rate, will (rightly, in our view) be based on an assessment of realized and expected economic conditions relative to the Fed's objectives of maximum employment and 2% inflation. As before, the Fed's analysis will take into account a wide range of information, including measures of labour market conditions, indicators of inflation pressures and inflation expectations (and information on financial and international developments).

As we also said in December, the key issue is inflation. Indeed, the Fed has stated that, in light of the current shortfall in inflation, it is intending to carefully monitor actual and expected progress toward its inflation goal (2%).  The Fed expects economic conditions to evolve in a manner that warrant only gradual increases in the federal funds rate.  Therefore, the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.  This would appear to move the Fed away from its earlier monetary policy of potential quarterly, albeit marginal, rate increases, and also appease those segments of the market looking for an even more accommodative stance from the Fed.

In summary, we are pleased that the Fed has refrained from being tempted to '˜dance to the markets' tune', while at the same time demonstrating that they fully understand that this may be as much a game of gradual confidence building as it is of overall market liquidity management. Essentially, the message from the Fed is '˜it'˜s ok, we are watching'.

 The result is that the markets did not get the short term fix they were longing for so, but will instead have to - like the Fed - watch the developing direction of macro-economic reports for clues about future monetary policy. To this end, better than expected US company revenues and earnings reports this past week, as well as a stabilising oil price, have provided markets with much more fundamental and confidence building guidance than the Fed statement could ever have.