The January FOMC meeting ended without incident, and without major change in strategy or language, as expected. There are four new FOMC voting members this year, but this didn’t change the overall tone (no dissenters this time). In the formal release, they upgraded language for economic activity as expanding from a ‘moderate’ to now ‘solid’ pace, and job gains from ‘solid’ to ‘strong.’ The decline in energy prices was noted as a positive for household purchasing power. The ‘considerable time’ language for a low rate regime was removed, while the ‘patient’ approach was retained.
Investor focus continues to be on when the current zero rate regime will end, which looks to be mid- to later-2015, based on how economic data looks between now and then.
For curiosity’s sake, it’s sometimes interesting to take a look at the Fed futures markets for a view on where participants expect rates to fall in coming months. For the January and March meetings, there was a 0% chance of a rate hike priced in (maybe not entirely surprising, but a 0% chance of anything is a little bit surprising). A Fed Funds rate of 0.25% remains the highest probability through much of the year, when the chances of a 0.50% rate finally surpass it. At that point 0.75% is priced in at a 1-in-5 chance, but becomes the highest probability in January 2016. When condensing this down, the chances of rates increasing have lowered in magnitude and timelines have been pushed out during the past few months.
Looking at the dashboard:
Economic growth is expected to fall in the 3% range for Q4, with hopes for a few ticks better into the low 3’s in 2015. Relative to the slow start post-crisis, and a few mid-cycle hiccups, this level is decent and the scope of the recovery has broadened with a few notable exceptions (a big one being housing). Debate continues about which stage of the economic cycle we’re in, but the latter end of early and early part of mid-cycle seems to be where the charts fall.
Inflation remains below the Fed’s 2% target, and while it’s obvious cheaper energy has played in role in the low headline number, this is the mandate perhaps most disconcerting to committee members, based on the traditional economic relationship of growth and inflation moving upward together. As Ben Bernanke noted so many times during his tenure, a little bit of inflation is a small price to pay to avoid a damaging bout of deflation, a condition that can be a bit trickier to break out of, for several reasons (as Europe is currently finding out). On the interest rate side, U.S. real rates generally remain on the lower side relative to historical averages and bond investors are generally showing complacency about long-term inflation risks.
Employment numbers have also improved, and fairly dramatically, when looked at from a multi-year post-crisis perspective. The ultimate target of ‘full employment’ is a theoretical place, and there’s no great way to measure where that lies (although economists believe it’s somewhere in the 5.0-5.5% area). We’re getting close to that now, but some hurdles continue to hold the Fed back from becoming too exuberant, including slower-moving labor force participation rates, quit rates, wage growth and a few other metrics that aren’t showing this same strength. Yellen’s entire career has been focused on labor, so no doubt it’s being heavily scrutinized.
From an investment standpoint, interest rates obviously remain quite low, and that condition alone acts as a stimulative impulse to risk assets. Another camp asks (legitimately): why are rates still so low? There are probably several reasons, including low inflation (the biggest factor affecting rate trends long-term); a bit of anchoring to low yields in developed nations elsewhere in Europe and Japan, since the relatively higher rates here look not so bad compared to 0.50% in Germany; lower Treasury issuance as U.S. budget deficits have shrunk a bit; as well as a general remaining skittishness in the post-crisis years. Stocks can perform well in a low inflation environment, even at more extended valuations, but earnings growth may need to be the catalyst from this point rather than price ratio expansion. Foreign assets, beaten-up for several years due to a variety of crises, selectively look attractive from a valuation standpoint and could be the beneficiary of European easing just announced. This coincides with a general ‘decoupling’ of global central bank policy into more normal diverging views.