Under its new chairman Janet Yellen, the United States' central bank is gaining a reputation for market-friendly monthly meetings on monetary policy.
The Federal Reserve's most recent meeting last Wednesday contained few surprises, with members unanimously agreeing to trim monthly asset purchases by another US$10 billion (S$12.5 billion) and largely keeping to their upbeat assessment of the US economy.
The Fed also "reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate" to support the burgeoning recovery, it said in its post-meeting statement.
Dr Yellen further cheered investors by saying at her press conference that although a shaky first quarter led to the Fed cutting its growth outlook for this year, there are good reasons to expect a better economic performance in the next two years.
Rising employment, stock and home prices, together with lower household debt and the Fed's loose monetary policy, should propel the economy's expansion next year and in 2016, she said.
In addition, she seemed sanguine about heightened risk appetite in the financial system and accelerating inflation. US stock markets are at or close to record highs, while inflation has picked up pace to hover near the Fed's comfort level of 2 per cent.
But Dr Yellen said that US stock valuations were within their historic range compared to corporate earnings, and that recent inflation readings, while on the high side, were "noisy" and "roughly in line" with expectations.
Traders took this to mean there is little concern at the Fed about abundant liquidity leading to excessive risk-taking or inflationary pressures, which in turn implies little urgency in raising interest rates.
As expected, they responded with jubilation. The S&P 500 hit another record high last Wednesday, prompting gains in Asian and European stock markets as well. Measures of market volatility sank, indicating more optimism.
But a closer look at the Fed's updated projections released after the meeting indicates two slightly worrying signs. First, there are hints that a rise in short-term interest rates - the event every investor has been warily awaiting - could occur more rapidly than earlier thought. Fed officials said they now expect the Fed funds rate, a key rate against which short-term interest rates are benchmarked, to rise to 1.25 per cent by the end of next year, up from their March prediction of 1 per cent.
They also see the rate, which is currently near zero, rising to 2.5 per cent in 2016 - higher than the 2.25 per cent previously forecast. In other words, when interest rates do rise, they will climb at a faster pace than expected. This is particularly relevant for economies like Singapore, where interest rates closely track US rates.
Economists such as ABN Amro's Peter de Bruin and Hans van Cleef expect short-term rates to start rising as early as the middle of next year.
"There is less slack in the economy than the Fed believes," they said in a report last week.
The second worrying sign is that the Fed appears to have cut its expectations for the US economy's long-term growth rate. Even as officials hiked their forecasts for short-term rates, they lowered their projections for long-run rates, a clue that they anticipate a less robust expansion of the economy further down the road.
Looking at the picture as a whole, therefore, the rosy view that markets are taking of the Fed's steady and accommodative steering of monetary policy may be somewhat premature.
As the central bank nears the final exit of quantitative easing, it will have to more decisively balance the competing concerns of keeping inflation in check, maintaining interest rates at low enough levels to sustain the economic recovery, and ensuring the long-term growth potential of the US economy.
This article was first published on June 23, 2014.
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