A cautious Federal Reserve left interest rates unchanged Wednesday, acknowledging global risks but still setting the stage for tighter monetary policy in response to a stronger U.S. labour market and rising inflation.
The Fed is now signalling two modest rate hikes this year of a quarter of a percentage point each, reduced from an earlier projection of four increases, partly in response to stiffening global economic and financial headwinds and their impact on U.S. economic prospects.
Most Fed watchers had predicted policy makers would leave rates alone this month. But the overall tone of the comments from the world's most powerful central bank was more dovish than some analysts had expected.
"We and most market participants expected something slightly more hawkish that would send a stronger signal that rates could rise again in mid-year," Société Générale strategist Kit Juckes said in a note. "As it is, the chances of an April hike seem very remote, and June is possible rather than probable."
The Fed boosted its benchmark rate in December by a quarter of a percentage point from near zero, where it had been fixed since the depths of the Great Recession. Policy makers have stayed on the sidelines since then, amid mixed U.S. economic data, a slowdown just about everywhere else and a bout of severe turbulence in global financial markets.
The statement Wednesday by the policy-setting Federal Open Market Committee noted that "global economic and financial developments continue to pose risks."
Asked about specific concerns, Fed chair Janet Yellen told a news conference after the FOMC meeting that slowing Chinese GDP was expected, but that Japan's negative fourth quarter "was something of a surprise." She also noted signs of weaker growth in the euro area and the toll taken by the oil slump on the economies of emerging and developed exporters, including key U.S. trade partners Canada and Mexico.
Further tightening now would have widened the divergence between Fed policy and other major central banks, which are contemplating more monetary easing to cope with deepening domestic troubles. The undesirable result would be an even stronger U.S. dollar, lower inflation and increased pressure on U.S. exporters.
But Ms. Yellen said the weaker global outlook hasn't prompted the central bank to change its relatively positive outlook for the U.S. economy.
The Fed's "projection for global growth … is slightly lower, not dramatically lower, but enough lower to make some difference to our forecast," she said. This, along with concerns about the impact this is having on corporate borrowing costs and the potential effect on investment decisions, has led policy makers "to think that a slightly lower path for the federal funds rate will be appropriate to achieve our objectives."
As a result, "what you see here is a virtually unchanged path of economic projections and a slightly more accommodative path … for what is necessary to achieve that."
The Fed expects the job market to continue strengthening, with unemployment sliding to 4.7 per cent by the end of this year and falling further in subsequent years. Yet, it has slightly lowered its outlook for both economic growth and inflation – expecting the latter to remain below the 2 per cent target through next year – and reduced its long-term rate forecast to 3.3 per cent from 3.5 per cent, which implies that we won't be seeing an economic boom any time soon south of the border.
The Fed's policy doves, led by Ms. Yellen, seem likely to hold sway, particularly now that inflation is expected to reach only 1.2 per cent this year, down from the Fed's earlier forecast of 1.6. Gauged by Fed funds futures trading, the market is expecting the next modest hike in June and one more before the end of the year. But that is by no means a sure bet.
"Reduced uncertainty about global economic and financial developments or further meaningful gains in the labour market and core inflation, or some combination of all of these, would appear to be the necessary condition for the next normalization step," Michael Gregory, deputy chief economist with BMO, said in a note.