Is the Fed really as dovish as markets think?

1. Page 1 of 2
Economic Commentary
QNB Economics
economics@qnb.com
27 March 2016
Is the Fed really as dovish as markets think?
The Fed gave markets a dovish surprise on the
16th
March when it revised down its
projections for the policy rate in 2016 from four
hikes to two hikes of 25 basis points each. The
move was a bigger downward revision than
expected and led to lower market interest rates
in the US and a weaker dollar. This provided a
reprieve to central banks around the world,
freeing up space for easier monetary policy.
However, there are a number of reasons to
believe that markets may have overreacted to
the Fed’s dovish messages and a more hawkish
surprise could be in store down the road.
Projections of US policy interest rate
(%)
Sources: Bloomberg and QNB Economics
After its March meeting, the Fed kept its main
interest rate target unchanged at 0.25%-0.5%,
as expected. However, it lowered its
projections for policy rates at the end of 2016
from 1.375% in December to 0.875% currently.
It is possible to decipher four main reasons for
this downward revision.
First, the Fed stated that global economic and
financial developments pose risks to the
economic outlook. The start of 2016 has been
plagued by severe volatility in global financial
markets (see our previous commentaries,
China’s devaluation creates spillover risks in
some EMs and Are markets overreacting to
weak global economic data?). This has
prompted the Fed to become more cautious
about raising rates.
Second, weak US economic data early in the
year has led to a small downward revision to
the Fed’s real GDP projections. The Fed now
expects the economy to expand by 2.2% in
2016 compared with a forecast of 2.4% in
December.
Third, the Fed has revised down its estimate of
the long-run unemployment rate from 4.9% in
December to 4.8%. This is the rate at which
the Fed considers the economy to be at full
employment. With unemployment currently
at 4.9%, lowering the estimate of long-run
unemployment reduces the pressure on the
Fed to raise interest rates to cool the economy.
Finally, the Fed has revised down its
projections for headline inflation at the end of
the year from 1.6% in December to 1.2%, as a
result of lower oil prices. This is well below the
Fed’s target of 2%. The Fed’s key inflation
measure is core inflation (excluding food and
energy), which has not been revised down.
However, the Fed may be taking the lower
headline inflation numbers into account.
Lower US interest rates could be beneficial for
the world economy by easing monetary policy
at a time when other major central banks may
be running out of options to spur growth. The
policy interest rates of the two other major
global central banks, the Bank of Japan and the
European Central Bank, are sinking deeper into
negative territory and their quantitative
easing programmes are losing efficacy (see our
commentary ECB, big gun but running out of
0.375
0.875
1.375
0.685
0.595
0.00
0.25
0.50
0.75
1.00
1.25
1.50
Mar-16 Jun-16 Sep-16 Dec-16
Fed projections in
December 2015
Fed projections in
March 2016
Futures markets
after Fed meeting
Futures markets
before Fed meeting

2. Page 2 of 2
Economic Commentary
QNB Economics
economics@qnb.com
27 March 2016
ammunition?). In emerging markets, lower US
interest rates and a weaker dollar provide more
room for central banks to cut rates without
instigating capital flight and weaker exchange
rates. A number of emerging market central
banks have already lowered rates since the
Fed’s meeting, such as Bank Indonesia and,
reportedly, the People’s Bank of China.
However, the stimulus from easier monetary
policy by a dovish Fed may not last. There are
a number of reasons to believe that there are
upside risks to the Fed’s central projection of
two hikes this year.
First, the global economy appears to be getting
back on track after a rough start to the year
and global financial markets have recovered
(see our commentary Markets set the stage for
Fed rate hikes).
Second, the jobs market in the US remains
strong and the economy could soon rise above
full employment, increasing the likelihood that
the Fed would raise interest rates.
Third, the Fed’s projection of two hikes is
based on the median of forecasts generated by
the participants in Fed meetings. However, a
significant proportion of participants still
expect more than two hikes. Out of 17
participants, nine project two hikes this year,
seven project more than two hikes and only
one projects a single hike. This suggests that it
would not take a significant improvement in
US economic data to tip the Fed back towards
a higher number of rate increases.
Finally, the Fed’s forecasts for inflation could
be too low. Core inflation unexpectedly rose to
1.7% in January from 1.5% in December,
rapidly approaching the Fed’s 2% target. The
Fed expects this measure of inflation to ease
during 2016 and is forecasting 1.6%, in line
with its projection in December 2015.
However, markets and a number of
commentators expect core inflation to remain
persistently higher.
Therefore, the market response to the dovish
Fed may be overdone and markets could have
set themselves up for a hawkish surprise down
the line. As long as there are no more shocks to
economic growth and global financial markets,
more than two Fed rate hikes could still be on
the cards this year, which could lead to a
stronger dollar and tighter monetary policy in
emerging markets.
QNB Economics Team:
Ziad Daoud
Acting Head of Economics
+974-4453-4642
Rory Fyfe*
Senior Economist
+974-4453-4643
Ehsan Khoman
Economist
+974-4453-4423
Hamda Al-Thani
Economist
+974-4453-4642
Rim Mesraoua
Research Analyst
+974-4453-4642
* Corresponding authors
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