At the beginning of the year, the bond market and the Federal Reserve seemed to be on the same page as far as the outlook for interest rate increases this year. As the year progressed, the two viewpoints diverged (see last week’s commentary for more details). The stock and bond market’s enthusiasm for tax reform and fiscal stimulus waned. Economic growth in the first quarter came in below expectations and inflation remains under the Federal Reserve’s 2% target. Yet the Federal Reserve remained steadfast in their outlook for the year.
This week we saw the first crack in the Federal Reserve’s outlook for interest rates. The chair of the Federal Reserve’s Open Market Committee (FOMC), Janet Yellen, gave her semi-annual congressional testimony. Yellen reiterated the Federal Reserve’s outlook for gradual increases but added a willingness to change course if inflation remains under the 2% target. The markets took this statement as “dovish”. Which means the market believes the FOMC is being accommodative, more likely to keep rates lower for longer. No change is expected at the July meeting.
Yellen commented that the FOMC plans to begin shrinking its balance sheet soon, but again added a willingness to change course. The indication is the FOMC will begin reducing the balance sheet in September so a rate hike at that meeting is unlikely. The next expected rate hike decision might not be until the December FOMC meeting.
The FOMC still believes that low inflation is transitory and will resume its path to its 2% target over the medium term. The bond market has a more pessimistic outlook for inflation and interest rate hikes. It looks as if the Federal Reserve is setting the stage to come down closer to bond market expectations. We will have to see which viewpoint wins in the end.Back to Articles