This year, the Fed will be more defensive

Since raising its key interest rate in December, the U.S. Federal Reserve has become more defensive, says Royce Mendes of CIBC World Markets in a research note.

In fact, according to the Fed’s January meeting minutes, the Federal Open Market Committee (FOMC) voted unanimously to stand pat on rates due to concerns about continuing threats to the U.S. economy. These include turbulence in financial markets, plunging oil prices, and slowing growth in China and other emerging markets.

Currently, the central bank says the timing of further rate increases will depend on the strength of economic data, says Mendes. Plus, recent speeches from several notable Fed members have hinted there’s little chance of a rate hike in March.

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Mendes notes, “The Fed won’t be able to raise rates until later in the year and even then, [we believe] the central bank will only be able to raise rates twice—a path that is still more aggressive than what the market has priced in.”

The Fed’s minutes, released today, show officials took global developments into consideration. They also acknowledged global weakness has made it difficult to forecast growth and inflation prospects. As a result, the Fed decided that it would be prudent to defer a hike.

Still, Fed officials are optimistic about labour markets. The minutes say, “Conditions continued to improve in the fourth quarter of [2015], even though growth in real gross domestic product appeared to slow. [But], consumer price inflation was still running below [FOMC’s] longer-run objective of 2%, restrained in part by decreases in both energy prices and the prices of non-energy imports.”

Also, “Measures of longer-run inflation expectations were little changed […] while market-based measures of inflation compensation declined further.”

The Fed was less bullish on other parts of the economy, such as manufacturing. The minutes say, “Most participants indicated that it was difficult to judge at this point whether the outlook for inflation and economic growth had changed materially, but they thought that uncertainty surrounding the outlook had increased as a result of recent financial and economic developments.”

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And, some FOMC officials say economic downside risks have increased. The minutes says the risks to the U.S. economy are “more pronounced than in December, mainly reflecting the greater uncertainty about global economic prospects and the financial market turbulence in the United States and abroad.”

Based on the Fed’s standstill and its defensive outlook, many private economists have cut their forecasts for Fed rate hikes this year from four to two or fewer.

In a recent speech, Fed chair Janet Yellen has also stressed the central bank isn’t on a “pre-set” course for rate hikes and that it will assess at its next meeting (March 15 and 16) whether recent developments are still a concern.

And, in a speech this week, president of the Fed’s Boston regional bank Eric Rosengren stated that global weakness may push back the Fed’s timetable on inflation. He said, “In my own view, if inflation is slower to return to its target, monetary policy normalization should be unhurried. A more gradual approach is an appropriate response to headwinds from abroad that slow exports and financial volatility that raises the cost of funds to many firms.”

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