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Economic Outlook - JANUARY 2016

To state the obvious, financial markets have been in a state of turmoil since the beginning of the year. The year 2016 started with a plunge in global stock markets and sharp declines in yields on “safe” sovereign debt amidst volatility in currency exchange rates, rising geo-political tensions, further declines in commodity prices, and signs of fading activity in some global economies. There have also been signs pointing to slowing momentum in the U.S. economy. The first estimate for GDP for the fourth quarter was a 0.7 percent annualized quarterly rate, down from 2 percent the previous quarter.

 

While there are reasons to be cautious about the future, the U.S. has held on to a moderate expansion. It’s as if the economy is running at two speeds. The headwinds on the factory sector have arguably intensified over the past few months, with slower export activity that is in part due to further appreciation of the dollar. There have also been widespread cutbacks in the energy sector and with commodity prices having slipped further, activity in this sector should also remain subdued. On the other hand, the service sector, which accounts for eighty percent of employment, has continued to fare reasonably well against the backdrop of these developments. Consumers remain confident by historical standards, buoyed by a healthy labor market, lower household expenses for energy and rising home values.

In an environment with more than the usual uncertainties and where the markets were casting increasing doubts on the Fed’s economic and inflation outlook, the FOMC held the line on rates at the January 26-27 meeting and said it still expected to increase the targeted fed funds rate “gradually” in the coming months as economic conditions improve. The language of the policy statement, however, turned slightly more cautious. Growth was recharacterized as having “slowed” from a previously “moderate pace.” More specifically, the “solid” pace of activity for consumer spending and business investment was also downgraded to “moderate."

 

The softer tone in the statement reflected both concerns about inflation and global economic and financial developments. In the January statement, the Committee omitted language describing the chances of faster and slower growth as “balanced.” Instead, it said “that 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,” suggesting that downside risks may be growing, and may begin to weigh on the outlook for growth.

 

Also in a key change to the statement, the Fed dropped language it had used in December that it was “reasonably confident” that inflation would reach the Fed’s 2 percent target over the next few years. This may reflect concern that inflation has fallen further as a result of a further drop in oil prices and a stronger dollar. While members still see these factors as “transitory effects” that will dissipate and allow inflation to rise over the medium term, the Committee is less certain that low inflation will give way to increased pricing pressure in the near term.

 

 

 The bottom line of the January meeting is that nothing was ruled in and nothing was ruled out. The Fed, based on the tone of the policy statement, does appear to be a bit less confident about their relatively optimistic growth in inflation outlook that underpinned their decision to begin rate normalization in December and the resultant “dot plot” that projected four rate hikes in 2016. The quality of incoming data along with the evolution of financial market conditions will dictate whether or not the Fed moves forward with another step in the rate normalization process at the March meeting. In order to continue to raise rates, the data-dependent Fed will need to see hard evidence that employment metrics and inflation indicators are proceeding in line with its forecast. The markets see the odds of a March rate hike as greatly reduced, but it cannot yet be completely ruled out and for the time being, remains our base case.