The Fed reaffirms it's on hold

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      By Eric Stein, CFACo-Director of Global Income, Eaton Vance Management

      Boston - As expected, the Federal Open Market Committee (FOMC) held the federal funds rate in a target range between 2.25% and 2.5% this week. Wednesday's announcement noted that inflation has declined recently, which initially led to increased market expectations of a future rate cut.

      However, Fed chair Jerome Powell in his post-announcement press conference repeatedly said low inflation was "transient," and that language certainly had a hawkish tone to it relative to the increasing chatter that the Fed was "missing" to the downside on its inflation target.

      Putting it all together, it doesn't seem like much has changed at the Fed, though the tone of Powell's comments meant that the Fed didn't get more dovish at this meeting as it has at the previous meetings. The economy continues to grow and unemployment remains low, but inflation in the price index for personal consumption expenditures (PCE) is below the Fed's 2% target, although other inflation measures are higher, closer to the 2% target.

      Looking at the bond market, Treasury yields have declined since the end of last year when the Fed clearly made its dovish pivot. For example, U.S. 2-year Treasury Note yields have pulled back since nearly hitting 3% in November 2018. The 2-year yield dropped to about 2.2% on Wednesday afternoon as the tweak to the inflation language in the Fed statement fueled speculation of a future rate cut. However, yields reversed and rose during Powell's press conference.

      I think there a few main questions for the Fed to focus on. The first is how much to care about a few tenths of a percentage point "miss" on inflation. I personally think the Fed and all central banks should target a range on inflation as trying to target anything, particularly something as difficult to precisely measure as inflation, can be problematic and have unintended consequences.

      There had been a lot of chatter about the Fed becoming increasingly concerned about missing on its inflation target, but with Powell highlighting the Dallas Fed trimmed mean inflation,1 it seems that he is less worried about low inflation. Yet, even more important than which inflation measurement is best, will be the outcome of the highly anticipated conference in June hosted by the Chicago Fed where officials will discuss monetary policy framework and whether or not they should adopt a new framework on inflation that would encourage overshoots after periods of undershooting the inflation target, etc.

      The second main issue for the Fed to focus on is the link between its monetary policy and asset markets/financial stability. One of the main reasons the Fed turned hawkish last year was the froth in asset markets at the beginning of 2018. One of the main reasons the Fed turned dovish early this year was the sell-off in asset markets and subsequent tightening of financial conditions in December 2018. Powell mentioned the recent easing in financial conditions yesterday and while I think the Fed is a long away from tightening policy because of asset market strength, certainly the recent asset markets rally may be one reason Powell was incrementally hawkish yesterday.

      Increasingly, I think the Fed and many other developed market central banks will have the very difficult task of balancing both hitting their inflation target (there are many healthy supply-side factors keeping inflation low) with also maintaining financial stability and not allowing asset markets to get too frothy. I think they will oscillate between focusing on both of these two objectives and at times overdo it on each side.

      Bottom line: My own view is that the bar is currently high for the Fed to cut, or to hike. Wednesday's Fed policy announcement was dovish, but I believe Powell tempered some of the dovishness in his press conference because he doesn't seem too obsessed with the inflation miss on core PCE. For me, this means the bar to hiking is high, but the bar to cutting is slightly higher than before this week's Fed meeting. So, the Fed is in wait-and-see mode on the economic and inflation data. If inflation continues to fall, that could change the current view. But for now, Powell thinks the Fed's current policy is appropriate based on current economic growth and inflation.