The Daily Update - Patient Fed & IOER

As expected, the FOMC left the Fed Funds target range unchanged at 2.25-2.5% and stuck with its ‘patient’ approach. Given the recent soft PCE data the Fed’s view on inflation was a key focus. The FOMC statement acknowledged a softening in the inflationary backdrop stating ‘On a 12-month basis, overall inflation and inflation for items other than food and energy have declined and are running below 2 percent.’ However, Jerome Powell’s comments in the press conference sent a cautionary warning to the market doves.

He noted: ‘Core inflation unexpectedly fell as well, however, and as of March stood at 1.6 percent for the previous 12 months. We suspect that some transitory factors may be at work. Thus, our baseline view remains that, with a strong job market and continued growth, inflation will return to 2 percent over time’. Plus, he commented ‘risks have moderated somewhat’ since the start of the year, ‘we think our policy stance is appropriate at the moment, and we don’t see a strong case for moving in either direction’. Thus, at the time of writing the Fed Futures had toned down the probability of a rate cut by year-end to ~52% from ~67% pre-meeting.

In what Jerome Powell described as a ‘small technical adjustment’ the Fed reduced the IOER (interest paid on excess reserves) rate 5bps to 2.35% to help keep the Fed Funds rate within the target range.  Whether the Fed will look to change its policy rate to something akin to this deposit rate in the future is another area of debate. Bob Gay, our macro-economist, expects such a change and notes: QE has left banks with huge untapped reserves at the Fed, and not surprisingly the deposit rate on those reserves has become much more important in defining policy than the funds rate. I do not expect this change in framework to be disruptive to financial markets, although it will generate lots of speculation about the Fed's intentions in the months ahead. I expect the change to take place at the conclusion of the staff's current review of its monetary framework sometime later this year. A change in the inflation target to say 3% is not likely. Running the economy 'hot' has become a darling in the media, changing target for inflation is a favourite simplistic option. On the contrary, the evidence on the consequences of 'overshooting' is far more nuanced: running hot may actually have perverse distributional effects including heightened systemic risk without providing much in the way of permanent jobs for disadvantaged workers. In short, 'running hot' is not all that it is cut out to be and may be worse, or even much worse than doing nothing.

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