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Fed Note - December 17, 2015

Fed Note - December 16, 2015

Guest Post - Wednesday, December 16, 2015

The December meeting was again slated to be 'the one', as in the meeting where interest rate policy changed for the first time in a decade and almost exactly seven years after the fed funds rate was cut to just over zero. And it finally happened. The target fed funds rate has moved from 0.00-0.25% to 0.25-0.50%, so the equivalent of a quarter-percent move.

The FOMC statement alluded to the economy expanding at a moderate pace, with strength in household spending and business fixed investment, and improvement in housing. Gains in the labor market were also noted with 'underutilization' having decreased significantly. Mostly, a lack of bad economic news appeared to be a major catalyst. There were no dissenting votes, which was also interesting, especially from the more dovish/accommodative camp that previously argued for continued zero-rate policy.

As strange as this would sound historically, the Fed has been under a lot of pressure to get the ball rolling. In past years, begging a central bank to raise interest rates would have sounded absurd, but keeping rates at near-zero levels for seven years may have sounded absurd in its own right. It's important to keep in mind the backdrop of this decision—important since clients who watch national or 24-7 financial news might get the wrong impression from this. This doesn't equate to an extreme tightening of any kind, and no doubt Janet Yellen's press conference going on right now is 'smoothing things over' on that front. The U.S. economy is not in a mode of economic hyper-growth, and there is no rampant inflation or obvious credit excesses that need to be reined in, at least that are apparent on the surface. Instead, this is taking a policy of extreme accommodation and moving the needle back towards where normal interest rates should be for this stage of the cycle. But it's still likely a long road considering the low levels we're starting from.

On the other hand, there are different forms of monetary tightening—it's not just the Fed that controls this. Banks being choosier about lending and a strong dollar that can hamper exports are other vehicles through which an economy can experience tighter conditions, and it could be argued that some of these have taken up some of the Fed's work. Additionally, recent concerns in credit markets—energy/materials specifically—have caused bond yield spreads to widen, and that is also a form of tightening that is controlled by markets as opposed to the Fed.

The key metrics as they look now:

Economic growth: This has not changed radically, as estimates for overall GDP growth in 2015 remain in the 2.0-2.5% area. While growth in services (bulk of the economy) is strong, manufacturing has been a weak spot. This is better than Europe or Japan, but it isn't strong compared to the robust post-WWII environment of 3%+ that many expect from the U.S. in perpetuity. As we've mentioned previously, some of this is demographics, some is likely related to productivity, some is carryover from de-levering after the financial crisis and some is just related to global cyclical factors. The lower absolute levels of growth versus the relative strength of growth compared to other nations has to be weighed in policymaking; the strong U.S. dollar is a tangible example of what can diverge in relative terms.

Inflation: The oil price bust of the past year significantly impacted traditional inflation measures, as energy is a key component—the newest year-over-year CPI number is now at 0.5%. Core inflation ex-food and energy has demonstrated more normal tendencies, rising at a pace more in line with the Fed's 2% target. In trying to find some secret formula that will provide at least some guidance as to where inflation is headed, many are watching wage growth, which has displayed a mixed but partially-correlated historical relationship with broader inflation, and a few components have shown signs of more pressure. All-in-all, the Fed would like to see inflation trend higher as a byproduct of stronger growth, but appears hopeful this will occur.

Employment: The November payroll number, that turned out decently as expected, was seen as an important milestone for Fed action. The Fed's dual mandate of employment vs. monetary stability is tricky at a time like this. Labor numbers have shown sharp improvements through payroll growth, a dramatically lower unemployment rate (in fact, near 'full' employment); in fact, metrics could be reaching the limits of the strongest marginal improvement. However, the 'quality' of the improvement, measured by challenges with labor force participation and proportion of lower-wage to higher-wage employment gains may not be as strong as the numbers depict. This is also seen in a breakout of the unemployment rate, with levels for certain ages and ethnic groups, as well as lower education levels, at dramatically higher levels than the broad average. If labor weren't a consideration, it's difficult to tell about potential policy decisions as overall growth levels aren't outstanding—yet, they likely don't warrant emergency levels of zero, either.

Economists and strategists are now arguing about the pace of rate increases—will it only be 1-2 increases in 2016 or as many as 4? Regardless, we can probably expect the Fed to continue communications nuanced toward 'slow and steady', as to not unduly rattle market expectations, and remain 'data-dependent'.

Based on some historical reactions to interest rate hikes, no doubt some clients assign negative connotations to this type of move. In a dramatic 'brakes on' type of tightening, all types of conditions for credit, including mortgages, auto loans, credit cards and business borrowing become more challenging. That time may still come, but it doesn't appear to be today. On the other hand, it may begin to finally reward savers (particularly retirees) who have been punished with ridiculously low rates on savings account, CD and money market products.

Investment returns are likely to remain data-dependent also (as usual).

  • As we've shown before, equity results tend to be focused on earnings, and as these improve, returns may coincide. Rate increases in the past haven't been the death of equities—in fact, they can be decent.
  • Bond results may be mixed as well, although we can expect more volatility, especially from the longer end of the yield curve which is strongly anchored to inflation expectations (inflation picking up may result in a much stronger/negative bond market reaction than Fed moves). While the U.S. business cycle has moved solidly into mid- to even later mid-, it's not over.
  • By contrast, however, Europe and Japan continue to push through QE stimulus to get their economies back in shape—such tendencies can be a tailwind for risk assets so it may not be surprising to see improved returns from foreign markets.
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