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Fed Note - March 19, 2015

Fed Note - March 19, 2015

Guest Post - Thursday, March 19, 2015

The FOMC, as expected, did not make any changes to policy, such as raising interest rates from current rock-bottom levels. However, the tone of the statement was a bit more neutral towards the subject, compared to the accommodative language seen in recent years.

Much of the discussion surrounded whether or not the FOMC would remove the key word ‘patient’ from the official statement. As was the case a decade ago when Chairman Greenspan did this, the change implies a rate hike could be appropriate at any upcoming time the committee chooses. Of course, there’s a lot of nuanced semantics here and the Fed remains careful to avoid a misinterpretation or misstep. April was downplayed as a possible jumping off point for rates, but this entire process as of late has been data-dependent, so could be June or a bit later. They’ve acknowledged the ‘moderating’ of conditions recently, and weakness in housing, but also the strength in labor growth and potential tailwind from lower oil prices. (Markets turned around in a positive direction upon hearing the moderating language.)

Looking at the mandate dashboard:

Economic growth conditions. With the appearance of a bit of a slow patch (weather-related or more than that) in Q1, GDP growth is expected to be in the 2.0-2.5% range, with improvement as the year presses on. This isn’t as strong as many would like, but is in keeping with the slow slog that has characterized this recovery. Importantly, it’s fast enough above stall speed that emergency easing conditions are likely no longer appropriate, and haven’t been for some time. The stronger dollar has been a bit of a headwind for U.S. firms, which the Fed is certainly aware of (albeit stronger domestic growth relative to that of other regions has been a primary cause of this strength).

Employment. With the unemployment rate falling close to the lower 5’s, it’s implied that the economy is getting extremely close to ‘full employment’—that theoretical place of normal joblessness that can’t really be improved upon easily from a long-term standpoint. This means that marginal improvements won’t nearly be as dramatic, even if the unemployment rate continues to fall a few tenths lower over time. Next, the FOMC is looking at measures not captured by the unemployment rate, such as U-6 ‘underemployment,’ JOLTS quit rates and outright wage growth—all of which have been a little weaker than the headline news. Could it buy them some time? Perhaps, but probably not much.

Inflation/monetary stability. This remains an interesting area, as it’s critical to separate the ‘headline’ inflation number (with energy and food) that’s running in slight deflation year-over-year, and the ‘core,’ which is not, but still below the Fed’s 2% target level. There is some carryover from cheaper oil that seeps into the core measure, in areas such as cheaper transportation, etc., which has likely depressed this figure as well. Now that employment is hitting the limits of what policy can accomplish, this has become a key FOMC focus. Expectations for future inflation are also low, although they’re higher in consumer/business surveys than they are in TIPs breakevens.

Low interest rates are a boost to risk assets, in a variety of ways, through cheaper financing of corporate and real estate deals, to a lower dividend discount rate that raises company ‘fair’ values. So, higher rates are a blessing and a curse. When they come, they put a damper on risk asset prospects somewhat, assuming that this impact isn’t offset by growth—which is the reason behind the higher rates to begin with (another economic conundrum). Bonds, most of which have fixed coupons, generally do not perform well depending on the timing and magnitude of increases (if rate rises are extremely tempered and elongated, it may mitigate the impact, as opposed to violent jumps). With no overabundance of credit being newly created (leading to financing bubbles, such as in real estate), inexpensive oil and a continued skittishness about foreign prospects, equities may continue to benefit if results defy expectations. It seems some segments of the bond market are on borrowed time—pardon the pun—even if returns simply are lower than the above-average results earned from the secular decline in rates up through this point.

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