Yesterday, as it is known, the Federal Reserve left the fed fund rate unaltered. This was precisely what was expected by analysts who, however, were partly surprised by the rather dovish tone of the statements made by Yellen, despite the actual conditions of the US economy not unlike those prevailing in December when instead the Monetary Policy Committee had fuelled expectations also in relation to four rises in the course of 2016. Whereas, yesterday, the rate projections formulated by the committee members imply only two interventions this year.
What could have lead the Fed to reconsider the rate profile? It emerges from Yellen’s press release and press conference that the high volatility on financial markets characterising the first part of the year, specifically stemming from fears about growth in emerging countries, China in particular, made the Fed more cautious – in technical terms, amended its “reaction function”. In fact, specific reference was made, not for the first time, to the financial conditions, deemed on this occasion more restrictive as compared to last December. A measure of the financial conditions is given by the indicator constructed by the Fed in Kansas City (Fig. 1) that actually shows a progressive increase in the past few months. Another observation expressed by Yellen is based on the estimate of the natural rate of interest (namely the interest rate compatible with conditions of full employment, potential growth and stable prices) that in more recent estimates appears to have dropped and that would therefore entail, ceteris paribus, lower rates. Lastly, Yellen hinted (even if not enunciated explicitly) that inflation overshooting would be preferable to inflation undershooting.
The reaction of the markets, at least a few hours after the decision, was moderate. The stock indices do not seem to have reacted negatively, as instead was the case in January. It remains to be seen how the bank indices will react, as the latter are the ones that have followed the trend of expectations on short-term rates more closely, to which movements are also correlated long-term rates, thus the term structure gradient (Fig 2). A further decrease in the spread between long- and short-term interest rates may determine a new review of expectations on banking margins, thus to the prices of the securities of the sector under scrutiny.