Was the Fed statement hawkish or dovish?

The Federal Reserve’s statement was largely unchanged from June, but that didn’t stop market participants from driving down the U.S. dollar. That reaction was largely reversed on Thursday, but it stems from disappointment that the central bank wasn’t more optimistic about the outlook, and because it seemed concerned that inflation would remain below two per cent in the near term.

However, the Fed indicated that it is sticking with its base case of gradual interest rate hikes, and added that its balance sheet unwind will start “relatively soon.”

So was the statement hawkish or dovish?

There wasn’t much to work with in terms of clues to the Fed’s thinking, as the committee only tinkered with words slightly. Yet the hawks should take some solace in the fact that the Fed is clearly preparing the market for tighter monetary policy.

The next rate hike probably won’t come until December, but the central bank shifted the language it used about letting bonds roll of its balance sheet from “this year” to “relatively soon.” That adjustment is intended to put the market on alert for an announcement at the next Fed meeting on September 19.

Avery Shenfeld, chief economist at CIBC World Markets, believes market hawks could also be relieved to see that the Fed didn’t add any words to indicate a greater uncertainty over the future inflation trajectory. However, it clearly remains frustrated by low inflation, noting that core inflation is running below two percent, whereas the previous statement had inflation at “somewhat” below two per cent.

“The Fed’s not quite so sure about where they go from here, so a virtually no news statement was the order of the day,” Shenfeld said.

The central back wants to raise the fed funds rate, but the lack of inflation pressure appears as though it will delay that move.

The removal of the “somewhat” qualifier suggests the magnitude of the divergence from the Fed’s target has increased, as both the overall and core inflation metrics were viewed as having declined.

“The Fed’s take on the economy appears relatively sanguine, with the current momentum seen as improved after some moderation earlier in the year,” said Michael Dolega, senior economist at TD Bank. “However, the Committee’s views of inflation took a dovish turn…”

Some viewed this change as a more significant development. Michael Gregory, deputy chief economist at BMO Capital Markets, said the interpretation that core inflation is definitely below two per cent “incrementally ratchets down” the odds of another rate hike in 2017. However, he doesn’t believe it rules out another hike this year.

“Things could go wrong… very wrong… with respect to a government shutdown or lifting the debt ceiling later this year,” Gregory said. “But presuming calamity is never a good hook to hang one’s forecasting hat on. All it will take is some success on the tax cut/reform front, and all Republicans will probably be playing nice in the sandbox again.”

With respect to inflation, he noted that U.S. consumer spending fundamentals remain healthy, corporate America still has plenty of cheap financing, and there is an urgent need to boost productivity.

“And we still judge the lion’s share of core inflation’s recent disappointing performance is idiosyncratic, and thus destined to fade,” Gregory said, forecasting the next rate hike in December.

Investors should also take note that the U.S. dollar is down more than eight per cent so far in 2017, which boosts the earnings potential of the many U.S. companies with large operations overseas.

Markets appear to be finding comfort in this development, as the S&P 500 continues to hit record highs despite the dysfunction in Washington, and the lack of any sort of reform or stimulus package on the horizon.