U.S. FOMC Continues to Taper Asset Purchases

The Federal Open Market Committee (FOMC) meeting resulted in a further $10 billion reduction in the pace of monthly asset purchases. Beginning in July 2014, the Fed will purchase $15 billion of agency mortgage-backed securities (MBS) and $20 billion of longer-term Treasuries per month, which would be down from $20 billion and $25 billion, respectively. No change was made to the fed funds target range of 0.00% to 0.25%.

The Fed also maintained its forward guidance that the fed funds rate will likely be held in its current range “for a considerable time after the asset purchase program ends.” The statement once again noted that economic conditions may warrant keeping the fed funds target “below levels the Committee views as normal in the long run,” even after the employment and inflation have reached “mandate-consistent levels.”

The statement noted that economic activity has “rebounded in recent months” following the 1.0% contraction in the first quarter, which was largely weather related. Consumer spending and business investment continue to advance, but growth in the housing sector “remained slow.” The statement made a nod to the recent decline in the unemployment rate, which fell to 6.3% in April and May from 6.7% in March, but continued to note that unemployment “remains elevated.” Inflation was once again characterized as “running below the Committee’s longer-run objective.” While the Committee’s rhetoric on inflation was unchanged, yesterday’s consumer price index (CPI) report, which showed annual headline and core inflation picking up to 2.1% and 2.0%, respectively, in May likely further limits downside risks to the inflation outlook.

Also released this afternoon by the Fed was its revised economic forecast. As expected, the range for 2014 gross domestic product (GDP) growth (on a Q4/Q4 basis) was lowered to 2.1% to 2.3% from 2.8% to 3.0% in March. This was largely due to the weather-related drop in output in the first quarter. The revised annual 2014 range still implies average growth in excess of 3% per quarter for the remainder of this year. Expected growth ranges for 2015 of 3.0% to 3.2% and 2016 of 2.5% to 3.0% were unchanged from previous projections. Despite the downward revision to growth expectations, the surprisingly large drop in the unemployment rate from the time of the March FOMC forecast update resulted in downward revisions to the expected unemployment rate profile. The expected range for the unemployment rate at the end of 2014 was lowered to 6.0% to 6.1% from 6.1% and 6.3% in March with the 2015 end-of-year range similarly lowered to 5.4% to 5.7% from 5.6% to 5.9% previously. The expected range at the end of 2016 was also lowered to 5.1% to 5.5% (previously 5.2% to 5.6%) and is now slightly lower than an updated “longer-run” range of 5.2% to 5.5% (previously was 5.2% to 5.6%).  Inflation forecasts were little changed. The projected range for headline personal consumption expenditure (PCE) inflation in 2014 is 1.5% to 1.7% versus 1.5% to 1.6% previously. The range for 2015 is unchanged at 1.5% to 2.0% while the 2016 range is slightly lower at 1.6% to 2.0% compared to 1.7% to 2.0% previously. Core inflation is slightly higher in 2014 at 1.5% to 1.6% (was 1.4% to 1.6%) but slightly lower in 2015 at 1.6% to 2.0% (was 1.7% to 2.0%) and in 2016 at 1.7% to 2.0% (was 1.8% to 2.0%).

The “dot plot”, which provides a summary of participants’ expectations for the fed funds rate at the end of the year, revealed only modest shifts. There remains only one participant who thinks the rate should be increased this year; however, there are now 11 participants who expect the rate to be 1% or higher at the end of next year compared to 10 previously. The median rate expected at the end of 2015 and 2016 are both slightly higher than in March at 1.13% (was 1.0%) and 2.5% (was 2.0%), respectively. Longer-run expectations have been lowered slightly; however, with a median longer-run rate of 3.75%, that is down slightly from 4.0% in March.

Overall, the broad economic outlook continues to evolve in line with the FOMC’s expectations. Economic activity has picked up following the weather-related slowdown earlier this year, with recent indicators pointing to solid underlying momentum in the second quarter. The strong pace of job growth in recent months has resulted in a somewhat faster decline in the unemployment rate than the FOMC expected, but unemployment remains elevated. We expect further improvement in economic activity and labour markets will allow the Fed to continue to taper asset purchases by $10 billion per meeting, with new purchases ceasing by the end of the year. Alternative indicators of labour market slack, however, including the elevated share of long-term unemployment and broader measures of the unemployment rate remaining high, still argue for the Fed to maintain highly stimulative monetary policy for some time. While some measures of inflation have picked up recently, the significant degree of slack in the economy should prevent stronger price pressure from emerging in the near term even with expected improvement in the economy and labour markets. Our forecast assumes the fed funds rate will be held in its current range into late 2015.

Information contained in this report has been prepared by the Economics Department of RBC Financial Group based on information obtained from sources considered to be reliable. While every effort has been made to ensure accuracy and completeness, RBC Financial Group makes no such representation or warranty, express or implied. This report is for information purposes only and does not constitute an offer to sell or a solicitation to buy securities.

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