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Question of the Week - May 31, 2016

Question of the Week - May 31, 2016

Guest Post - Tuesday, May 31, 2016

What's the probability of the Fed taking action this summer?

It depends on the week. Without being flippant, economic data and comments from FOMC members themselves have varied dramatically, making such a forecast challenging. This is a question that has continued to baffle economists globally, who like to think they have a good handle on these things. In fact, some have gone to the trouble of altering their evaluation models to account for the probabilistic uncertainty that can't be measured well through other means.

The baseline case is that the Fed would very much prefer to continue and even ramp up the process of normalizing rates to higher levels. This is an acknowledgement that current rock-bottom rates are no longer appropriate or necessary in a non-emergency economic environment; albeit one with still-slow growth that, in some ways, appears to be evolving from mid- to later-cycle. The fear is the same as it has been: that rate hikes not anticipated by investment markets in advance could lead to asset price shocks as well as a negative financial impact of choking off needed growth in business and consumer spending—particularly in areas like capex and housing—where conditions have been most fragile during the most recent recovery.

Credit and foreign exchange markets had absorbed much of the Fed's tightening job, in the form of higher corporate spreads on debt and a stronger dollar, which challenged exports over the last several quarters and weighed on S&P earnings results. These two components have improved in recent months, though, allowing a general easing of overall financial conditions at the margin. But the Fed's general problem remains—that base policy rates are still arguably too low. While there doesn't appear to be a widespread problem with credit moving into speculative bubble territory generally (some think we're poised to get there again, as always), low rates for long periods of time have a tendency to push asset prices to higher valuations, as investors seek other alternatives for low-yielding savings vehicles. This has occurred, and is actually the goal in several other nations through a negative interest rate policy. (If you really want citizens or banks to spend/invest, stop paying them to save and make them pay you. At least that's the thought.) Eventually, though, the Fed would like to have more 'ammunition' when economic slowing occurs, and it's difficult to implement accommodative policy by lowering rates, as they normally would, when they're at today's low levels.

Consequently, many economists have been left scratching their heads as to the timing of Fed policy actions, with some reverting to qualitative text analysis of Fed member speeches and other models to measure changes in tone at the margin. But, again, when the mood changes by the week, this prediction process has become difficult if not moot. By looking at the Fed's dual mandate of monetary stability/inflation and full employment, one could argue the threshold has been met to some degree, but the more bearish folks argue the 'quality' of the inflation and job growth improvement is less than optimal.

This goes down the road of the longer-term secular stagnation argument, argued by some, which has demographic and technological components (as in trends of an aging population and lower productivity). Technological innovation, for one, is obvious in some respects (firing off 5 e-mails per minute is much more efficient than paper letters on a manual typewriter), but can difficult to measure with traditional metrics. Building widgets is much easier to get a handle on than ideas or network effects. The following graphic is one of our favorites in that regard, and tangibly demonstrates the evolution that's taken place in the economy from 'stuff' to 'services'.

Evolution of the desk
Source: Blackrock.

We see the implications already through manufacturing's decline in proportion to services in the economy, and the difficulty in measuring what America has become a world leader in—intellectual property and entertainment content. This is a long-term secular trend, but transformations can be difficult, and displacement of a variety of industries has ramifications on both consumerism and employment. As a side note to this, in fact, fears over a secular trend of job loss from automation have prompted the Swiss in early June to consider the world's first 'Universal Basic Income' program—essentially an institutionalized social security-type program that would pay every adult citizen the equivalent of about $30,000/year; interestingly, several other nations including Finland, Canada, Netherlands and Spain, are considering similar proposals. Chances of this passing in don't appear to be high at this point, and how this would all get paid for is another matter, but the fact that it's reached the ballot in the first place highlights long-term worries about employment displacements on broader populations, particularly in the areas of routine and less specialized labor. At the same time, these worries have been around for hundreds of years, if not longer, and humankind has somehow survived and (eventually) adapted to new technological realities. Political discussions about workforce 'retraining' and similar rhetoric strike at the core of this problem, and are likely more effective long-term than trade wars with enhanced use of tariffs and protectionist measures.

Global events aren't technically part of the Fed's mandate, but slow foreign growth (particularly in China) and the prospect of 'Brexit' uncertainly points to July as a jumping-off point. The Fed likely doesn't want to let foreign events influence their decisions, but the prospect for global financial market volatility around or in response to such events may drive timing to some degree. As it stands, the Brexit vote, which was deadlocked at close to 50/50 by oddsmakers a few months ago has tilted more toward staying than going, which has calmed markets.

A speech given by Fed Chair Janet Yellen on Friday was watched closely, as it was delivered just before the 'blackout' period set in place for several weeks before each FOMC meeting. The thought was that there would be 'hints' of what direction the Fed would be going in June and July—in light of some growth metrics improving, it would 'probably' be appropriate for a rate hike to happen. This boosted probabilities of action in June by about 10% to over 30%, while the probability of it happening by July rose from about 50/50 to just under two-thirds. The chance of it happening by September has moved up to 70%, and December, near 85%. Keep in mind these are based on futures prices and can change very quickly in response to the latest news.

Regardless, even if rates are bumped upward on the short end, the consensus for broader yield curve changes remains constrained, as inflation levels are low and global growth remains depressed. Such tempered moves could still result in some volatility for long bonds, and as well as adjustments higher at the more expensive front part of the curve.

Read our Weekly Review for May 31, 2016.

Read the previous Question of the Week for May 16, 2016.

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