Fed Note – September, 17, 2015”
Well, this FOMC meeting was the big one, or at least had the potential to be. But, again, investors hoping for higher rates were disappointed—the Fed kept rates as they are for now. In recent weeks, the probability of the Fed raising rates for the first time in a decade became less and less likely as the global (particularly Chinese) economic situation deteriorated, which was reflected in U.S. financial market volatility. While futures markets predicted this outcome, economists were split on the probability of something happening today.
In the official statement, ‘moderate’ growth remained the theme. While household and business spending were acknowledged as improving, weaker exports were also noted, as were ‘recent global economic and financial developments’ that were likely to keep inflation restrained. Foreign conditions represented most of the newer statement language, much of which doesn’t always change much from meeting to meeting. Jeffrey Lacker, from the Richmond Fed, was the sole dissenter, voting for a 0.25% increase. In other handouts, the ‘dot plot,’ which represents fed funds rate estimates from various Fed members, showed a decline in expectations to about 0.40% for this year, implying at least one rate hike, while GDP growth and inflation were both downgraded a bit.
The dashboard of key decision factors remains largely unchanged but continues to show complicated forces at work behind the decision:
Economic growth: Despite a 3.7% surprise in the 2nd quarter (reflecting some rebound from a poor weather- and labor issue-influenced Q1), expectations remain pinned in the 2.0-2.5% range for Q3. These estimates have steadily come down from more optimistic closer-to-3.0+% growth levels not all that long ago. In the near term, forces such as a strong U.S. dollar have been largely to blame for weakness in exports, while cheap oil has been a mixed blessing—resulting in a significant positive in the form of lower consumer and business input costs while negatively pressuring capex spending in the growing U.S. shale energy sector. There are other factors at play here, too, that we’ve touched on before, which could be temporary or more ominous. Demographically, developed nations overall (not only the U.S., but also Europe and Japan) remain challenged, which could perpetuate lower growth on a structural level than we’ve become used to in prior decades.
Inflation/monetary policy: Extreme energy price declines of over -50% are the dominant factor in year-over-year headline inflation, which is barely positive at +0.2%, while the stickier core inflation figure is just under the Fed target at +1.8%. FOMC members have expressed a lack of worry about upside inflation pressures at this time, relative to potential deflationary risks, so the Fed could be willing to let any inflation run for a bit. When you have several mandates to worry about, waiting for the perfect alignment of all is seldom a luxury.
Employment: This may have become a more difficult conundrum for the FOMC now that traditional labor measures have shown a pattern of gradual tightening in a variety of areas—from payrolls all the way down to jobless claims, JOLTs job openings and an unemployment rate that has fallen into their self-defined but floating target level of ‘full’ employment. While markets haven’t become tight enough to generate widespread wage inflation (officials would like to see a bit, actually), evidence shows that labor conditions have improved. There are other issues here, such as the wage disparities between high- and low-end jobs, as well as a trend of new jobs being more skewed towards the lower-paying service end, but these could also feature some structural components beyond the Fed’s immediate mandate.
While postponement of Fed rates hikes and a continuation of accommodative policy was seen as a positive for some time, we’ve seen this uncertainty about Fed policy becoming almost a bit of a negative to some degree. It’s almost as if markets are saying, ‘get it done already.’ This leaves the relatively minor October meeting (‘minor’ as no formal press conference planned) or December (more likely) as potential times for the interest rate tightening announcement. If conditions remain dire, the pessimists may have it right and this decision will be pushed into 2016.
Markets like certainty, as we’re reminded often. When decisions aren’t made when expected and chances for a policy error begin to creep up, markets become less comfortable. The Fed’s conundrum with raising rates has been written about perhaps more than any other financial topic over the last few years, but it comes down to finding that careful balance between finding that appropriate time for rate normalization to reflect a more normalized, healing economy and building back ammunition for a recessionary rainy day down the road, and acknowledging the downside risks of slow growth and even deflationary forces that would warrant continued low interest rates for an extended period.