Elder Discusses Dovish Fed Meeting, Implications for Brexit

The Federal Reserve reconvened June 14 and 15, and as expected, again held short-term interest rates steady while expressing uncertainty over when the next hike will come and where rates are headed long term. Baird sat down with Senior Fixed Income Analyst Craig Elder, author of “Fixed Income Weekly,” for his perspective on the meeting.

Baird:
Craig, what did you find most surprising about the Fed’s June meeting?

Craig:
The tone of this meeting was much more dovish than expected. Clearly the Fed is very skittish about raising interest rates anytime soon. While new projections still imply two hikes this year, a greater number of officials now see just one increase in 2016. The vote was also unanimous this time, unlike in recent meetings when Kansas City Fed President Esther George dissented in favor of a rate increase. It’s becoming very clear that the Fed will take a much more gradual approach to rate increases.

The March dot plots (a chart that shows where Federal Open Market Committee members think the Fed’s benchmark interest rate will be at the end of upcoming years and over the long term) showed the Fed fund’s target rate being increased to 1.875% in 2017 and 3% in 2018. However, the June dot plots were lower, showing 1.625% in 2017 and 2.375% in 2018. 

Baird: 
What economic factors played into the Fed’s decision to hold rates steady?

Craig:
While economic activity has picked up, the Fed recently expressed concern that the pace of improvement in the labor market has slowed. However, even though job growth was slow last month, the initial jobless claims numbers are still very strong. In my view, I do think the economy’s growing at a moderate pace. As far as inflation is concerned, the PCE core (personal consumption expenditures excluding food and energy prices) number rose to 1.7% in February. It is now back down to about 1.6%. The Fed has said that 2% inflation growth is their target, but they have indicated recently they would tolerate inflation above the 2% level. 

Baird:
Was Brexit a consideration for the Fed? 

Craig:
I certainly think it was. A vote on whether Britain will leave the European Union will take place on Thursday and in the long run, I think that matters a great deal more than the June Fed meeting. It doesn’t affect our GDP that much, as our economy’s actually fairly insular (exports are 12½% of GDP and only about 0.71% of U.S. GDP comes from U.S. exports to Britain1). But, a Brexit win will cause our Treasury yields to rally as money will move to safety. Long-term yields are being driven by what’s going on with other long-term yields – the more stable, high-rated countries like Germany and Japan. Ten-year German yields are near zero and 10-year Japanese yields are negative 15 basis points, which should keep our yields down in the short term.

The big unknown is what the global implications of the final vote will be. Will the rest of the countries remain in the European Union or will others follow a similar path? Overall, it creates uncertainty and anxiety that the markets don’t like, which leads to a lot more volatility.

Baird:
At this point, what are you expecting in terms of future rate hikes this year? 

Craig:
I think the Fed is going to stay as far away as possible from the presidential election, so I think the first chance of a rate hike will come in December unless inflation spikes, which I think is unlikely. I don’t think we’re going to see full normalization this decade, but I do think rates will drift higher eventually as global issues settle down.

1 Oxford Economics, “Brexit vote impact on U.S. asset prices,” June 10, 2016