The Fed Holds, For Now

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Includes: RINF
by: Kristina Hooper

By Kristina Hooper, Steve Malin and Greg Meier

Growing Odds for Zero Rate Hikes in 2016

Fed fund futures show investors becoming
increasingly skeptical of further Fed tightening

Growing Odds for Zero Rate Hikes in 2016 Sources: Chicago Mercantile Exchange (CME); Allianz Global Investors. Data as of 1/25/16.

Wednesday's Federal Open Market Committee (FOMC) decision to hold monetary policy unchanged took few investors by surprise. The move was well-telegraphed and the vote was unanimous. However, the dovish tilt to the FOMC's official statement was remarkable. It suggested that - while policymakers have not taken a March rate hike off the table - they might be questioning some of their more optimistic projections for 2016.

Four Factors Driving the Fed

Breaking down Wednesday's statement and comparing it to the last one, released in December (when the FOMC raised rates for the first time in nine years), four things become evident:

1. Inflation outlook weakens - The Federal Reserve (Fed) has a dual mandate of price stability and maximum employment, and on the inflation front, Wednesday's statement noted a further decline in "market-based measures of inflation compensation." This can be seen in the 10-year TIPS (Treasury Inflation Protected Securities) breakeven rate - the implied average inflation rate investors expect to prevail between now and 2026.

Last week, this number fell to 1.28%, the weakest since mid-2009. Policymakers expect inflation "to remain low in the near term, in part because of the further declines in energy prices, but to rise to 2% over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further."

2. Robust job market - In the time since the last FOMC decision, we learned that employers added a whopping 292,000 jobs in December, while unemployment held at 5% - well-below the 5.8% long-run average. Policymakers Wednesday remarked on labor market strength saying "a range of recent labor market indicators, including strong job gains, points to some additional decline in underutilization of labor resources."

3. Economic growth has eased - Wednesday's statement noted that "economic growth slowed late last year," which is a downgrade from December when policymakers thought output "was expanding at a moderate pace." We got additional color on US growth on Friday, January 29, with the Commerce Department publishing preliminary data on fourth quarter GDP.

4. International developments back in focus - For anyone watching the news in 2016, this might be the understatement of the year. Global equities are in the midst of the worst annual start in history amid concerns about Chinese economic growth, the health of the global commodities complex and, ironically, the outlook for Fed rate hikes. Policymakers added new text on this in Wednesday's statement, saying "The Committee is closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook."

All Eyes on Fed's March Meeting

Looking ahead, the next FOMC meeting is scheduled for March 15-16. Between now and then, we anticipate continued, above-average market volatility. This is, in part, because in March, the FOMC will provide updated economic projections. The most recent set of projections - released in December - showed policymakers believed conditions would warrant four rate hikes this year.

Investors are increasingly skeptical. On Monday, the futures market implied probability on four 2016 rate hikes was only 1.4%. Odds that the Fed won't hike at all were almost 1 in 3. How the gap between the Fed's projections and the market's expectations closes might be one of the defining events for 2016.

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