Fed stays on track

Matthew Peter, Chief Economist

The US Federal Reserve (Fed) raised the federal funds rate target range by 25 basis points this week to 1.0-1.25%. While the move was widely anticipated, the meeting and associated press conference provided a lot more clarity on current Fed thinking and the likely course for policy over the near-term.

Most importantly, the Fed delivered a message consistent to those over recent months, despite growing market concerns that the Fed may capitulate on its inflation outlook given recent soft readings. Market fears were exacerbated following another weak CPI report released during the FOMC’s meeting, which revealed a 0.1% drop in the headline CPI in May and a weak 0.06% increase in the core CPI. The momentum in core CPI has been most concerning, with the 3-month ended annualised rate of inflation slowing from 3% in the three months to February to 0% in the three months to May.

While the Committee is monitoring inflation developments closely,” the Fed views part of the recent weakness in inflation due to idiosyncratic factors, such as falls in mobile phone plan prices and declining prices of prescription drugs. Furthermore, Chair Yellen highlighted that “it’s important not to overreact to a few readings and data on inflation can be noisy.”

The messaging from the Fed is clear; they place more emphasis on the medium-term inflation outlook, rather than the most recent observation. On that front, while recent inflation outturns have disappointed, the FOMC continues to expect inflation to pick-up due to the strength of the labour market. In other words, as Chair Yellen noted, the Fed continues to believe in the Phillips curve, the economic theory which describes a short-run trade-off between unemployment rates and inflation rates.

Reflecting this sentiment, the Fed’s economic projections were broadly unchanged. The Fed downgraded its PCE inflation outlook by 30bps to 1.6% for 2017 due to the recent softer outturns, but left its 2018, 2019 and longer-run forecasts unchanged at 2.0% due to ongoing strength in the labour market. The Fed lowered its unemployment rate outlook by around 20-30bps each year to 4.3% in 2017, 4.2% in 2018 and 4.2% in 2019, while also lowering its longer-run unemployment rate from 4.7% to 4.6%. The outlook for real GDP was almost identical to the median expectation in March, with growth forecast at 2.2% over 2017 (up 10bps from March’s projection), 2.1% in 2018, 1.9% in 2019 and 1.8% in the longer-run (all unchanged from March).

Given the similar economic outlook, the Fed’s dot plot interest rates forecasts remained essentially unchanged, with the median FOMC expectation for another hike by the end of 2017, 3 hikes in 2018 and 3½ hikes in 2019. The median long-run expectation for the federal funds rate remained unchanged at 3%. In a nutshell, the Fed continues to forecast an improving US economy, leading to a tightening labour market and inflation returning to target. In that world, it is appropriate that the Fed continues to gradually reduce the amount of monetary policy accommodation within the economy.

The Fed also indicated that the reduction in policy accommodation will include a shrinking balance sheet; a move that could be considered a reversal of quantitative easing. This week, the Fed continued to re-iterate the likelihood of reducing the size of its balance sheet later this year and provided significant details on the mechanics of how this will be done. The Fed will stop re-investing the principal proceeds from their maturing asset holdings up to an initial cap of $10 billion per month ($6 billion for Treasuries & $4 billion for agency debt and MBS). The total cap will increase by $10 billion every three months to a maximum of $50 billion ($30 billion for Treasuries & $20 billion for agency debt and MBS).

What is the likely impact of the Fed’s balance sheet reduction? While the Fed is unsure of how much to reduce the balance sheet, our modelling of a US$2 trillion reduction causes our fair-value estimate of US 10-year government bond yields to rise by 18 basis points. Higher interest rates and a stronger US dollar lead to a fall in US GDP growth and inflation of around 10bps each.

The US is nearing the end of an era. Nine years after introducing quantitative easing, the US economy is finally strong enough to consider unwinding some of this unconventional policy. We expect the Fed will start the process in September and follow-up this move with another rate hike in December. However, whether the Fed remains on this track will depend crucially on whether we start to see a turnaround in the recent disappointing inflation readings.

Table 1: Financial market movements, 8 – 15 June 2017

Equity index



10-yr government bond



Foreign exchange



S&P 500





-2.5 bps

US Dollar Index (DXY)



Nikkei 225





-1.6 bps




FTSE 100





-0.2 bps









2.6 bps




S&P/ASX 200





-4.3 bps




Source: Bloomberg

Economic Update

United States

Fed raises rates as expected, despite low inflation

• The US Fed raised the federal funds rate target range by 25 basis points this week to 1.0-1.25%, as expected and priced-in by markets.
• Inflation data was released in May, with a 0.1% drop in the headline CPI and a weak 0.06% increase in the core CPI.
• Retail sales data was weaker than expected in May, with no monthly growth in retail sales (ex auto and gas) despite an expectation of 0.3%. However, growth was revised up in April.

Euro area / United Kingdom

Pressure on consumer spending increases in the UK

  •  Data released this week shows that real wages growth has turned negative in the UK, and is likely impacting consumption as evidenced by a fall in retail sales. Weekly earnings growth (excluding bonuses) fell to 1.7% YoY in the three months to April. With headline year-ended CPI rising from 2.7% in April to 2.9% in May (and core CPI increasing in May to 2.6%), wages are falling in real terms.
  •  As a consequence, retail sales (exc. auto fuel) declined by more than expected in May, with growth over the year an anaemic 0.6%, down from 4.6% yearly growth in April (and much weaker than the 1.9% yearly growth anticipated by economists).
  •  The Bank of England’s Monetary Policy Committee met in the wake of this data, and came close to raising interest rates, ultimately keeping rates unchanged at 0.25% after a vote of 5-3. However, all of the Committee’s members agreed that inflation could overshoot the bank’s 2% target by more than previously thought.
  • Industrial production data was also weaker than expected in April in the UK, growing only 0.2% in the month rather than the 0.7% expected by economists.

China / Japan

No change to monetary policy in Japan
  • Yearly growth in retail sales and industrial output in China were unchanged in May, remaining at 10.7% and 6.5% respectively. However, year on year growth in urban fixed-asset investment declined from 8.9% in April to 8.6% in May.
  •  In Japan, the BoJ kept interest rates on hold, while upgrading its view on the economy, in particular noting that private consumption had “increased its resilience”.

Australia / New Zealand

Labour market surprises to the upside in May
  • Labour force data was unexpectedly strong in May, with the unemployment rate falling to 5.5% on the back of robust growth in full time employment. This was the lowest the unemployment rate has been since February 2013, and is down from 5.7% in April.  
  • The positive jobs data contrasts with other indicators of the domestic economy, with survey measures of consumer and business confidence weakening following sluggish real GDP growth in Q1. 
  • In New Zealand, real GDP grew by less than expected in the first quarter with falls in construction activity and dairy exports. Growth of 0.5% in the quarter was stronger than the previous quarter’s growth of 0.4% however.

Sources: Thomson Reuters, Bloomberg, FactSet, ABS.

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