Fed Credibility Takes Another Hit

Fed Credibility Takes Another Hit  

The headline from yesterday's Fed decision was that the FOMC is now projecting two rate hikes this year compared to the four they projected on December 16, 2015. This immediately took down the dollar and pushed the gold price higher on heavy buying.

But the real story is a little more subtle. The currency and debt markets were clearly caught wrong-footed again. Not that these markets were expecting a rate hike at yesterday's meeting. But they did not expect such a dovish statement and for good reason.

At the December 16 meeting, the FOMC stated that they were raising the Fed Funds Rate for the first time in more than nine years because of anticipated overheating in the economy. The rationale was that gradual tightening at that time would help to ensure that inflation did not develop momentum which would require more aggressive rate hikes later. At the December meeting, the Fed projected a 2016 year-end unemployment rate of 4.7-5.0% and a Core PCE rate of 1.4%. At the same time, based on these projections, the FOMC stated that it expected four more rate hikes in 2016.

Based on what the Fed said in December, the Fed should have tightened again yesterday. The unemployment target has been met. So, too, has the PCE target (the Personal Consumption Expenditure index that is the Fed's favourite inflation measure). Core PCE is now running at 1.7%, well above the Fed's year-end target.

What does this mean? First, the Fed is not really data dependent. Second, the Fed probably has a much higher tolerance for inflation than the 2% target they have publicly embraced. Third, you can't rely on what the Fed says because it looks like they are making up policy and policy rationales on the fly.

This was not a good day for central banking credibility. As we have noted here frequently, the price of gold is the inverse of confidence in central banking (a hat tip to Jim Grant). So, this was a good day for the growing credibility of gold.