The Fed kept the overnight rate unchanged today, choosing to delay an increase owing to stubbornly low inflation, an uncertain outlook for global growth and recent financial market volatility. It appears that recent losses in China’s equity markets reflect deeper worries over growth prospects for the world’s second largest economy. Slowing growth in China has helped to trigger a dramatic drop in commodity prices, especially oil, which has put further downward pressure on U.S. inflation.
Currently, inflation in the U.S. over the past twelve months is only 0.3 percent, well below the Fed’s target of 2 percent. Much of this is owing to the strengthening in the U.S. dollar and falling commodity prices. Also, despite tightening labor markets, wages gains have remained extremely muted.
By holding the benchmark federal funds rate at zero to 0.25 percent, policy makers revealed their continuing uncertainty that inflation has not moved back to their 2 percent target, despite gains in the labor market. The Committee expects inflation to remain low for many months.
Federal Open Market Committee (FOMC) members revised down their expectation of unemployment this year and next to a few basis points below the current level of 5.1 percent. Inflation expectations were revised down, as were projections of the federal funds rate even though growth is expected to perform well.
Most participants expect the Fed to raise interest rates this year, although four Committee members expect the first increase to be delayed to 2016. Richmond Fed president Jeffrey Lacker dissented with the Committee’s decision, saying he preferred to raise the target rate by 0.25 percentage points now.
Concern was expressed regarding global economic uncertainty. Clearly, the slowdown in China has caught the Fed’s attention. Headwinds from abroad are affecting the Fed’s forecast. The federal funds rate is not expected to return to “normal” levels until the end of 2018. So when interest rates do rise, they will do so only gradually.
The median of the Fed’s long-term forecast was lowered to 3.5 percent from 3.8 percent in June. The Fed is forecasting a federal funds rate of 0.4 percent for 2015, 1.4 percent in 2016, 2.6 percent in 2017 and 3.4 percent in 2018, which all are lower than the central bank saw in June. The central bank projected less inflation, trimming its forecast for inflation this year, 2016 and 2017, and not seeing inflation reach the 2 percent target until 2018. At the same time, the Fed got more optimistic on the unemployment rate, lowering its projections for 2015, 2016, 2017 and the longer term.
This is good news for Canada where the economy is much weaker than in the U.S. and where the Bank of Canada is at least a year away from tightening. Chairman Yellen mentioned Canada specifically in her press conference, suggesting that the slowdown in Canada arising from the oil price rout is important as Canada is “an important trading partner” with the U.S. Clearly, interest rates will remain low for a long time and when they do rise, they will do so only gradually.