The FOMC meeting ended with little fanfare as theories continued to swirl about surrounding the timing of the Fed’s choice to raise interest rates. Will it be June or will it be September? Or, will it be later? The Fed didn’t provide a lot of hints other than anecdotal comments here and there that conditions remain ‘data-dependent,’ which is about as good of a crystal ball as we can get.
Today’s statement described a general slowing during the winter, coupled with a moderation in job gains, and a decline in household spending. Also, that business fixed investment softened, housing remained slow and exports declined. However, the tone remained generally optimistic, even if the language was little changed toward the positive—implying the Fed feels the weakness is transitory.
Our look at a few of the factors underlying the Fed’s various mandates:
Economic growth. The first quarter GDP number that came out this morning was weaker than expected, falling to +0.2% on an annualized, seasonally-adjusted basis. We’ll have more on the specifics in the weekly review, but the detractors were a stronger dollar, which translated to weaker export activity, and lower business investment (energy firms playing a role)—just all worse than first thought. Like 2014, a colder/snowier-than-normal winter likely also contributed, although that’s always more difficult to precisely quantify. Savings from cheaper oil prices appear to have been banked as opposed to spent thus far, although these take time to filter through; also gasoline experienced a different pricing dynamic than did raw crude, which tempered the positivity of the impact.
Employment. As conditions inch further toward ‘full employment,’ incremental improvements are less likely to be dramatic. Broad indicators such as the unemployment rate and jobless claims have steadily shown gains, while nichier measures like wage pressures and the ‘quit rate’ have improved but not by the magnitude some have hoped for by now. Cyclical measures overall appear to be stronger, but the structural headwinds of demographics and technological change remain ‘out there’ as multi-year concerns.
Inflation/monetary stability. Headline year-over-year CPI is dominated by the significant decline in oil prices—taking the figure into the negative. Using core CPI instead normalizes inflation up to the 1.5-2.0% range, which is more reasonable but still below the Fed’s target. They appear to be careful to not risk this falling further (a la Europe and Japan) into flat or even deflationary territory, which acts as a governor to hiking rates too soon. When will we see inflation? Rising utilization to ‘fuller’ capacity is one metric, and this has been happening sporadically, and, as noted above, full employment may pressure wages upward, resulting in eventual inflation pressures. Essentially, when ‘slack’ of any kind is reduced, systems ‘tighten’ and that brings an adjustment in pricing….classically transmitted as inflation. On the positive side, carryover from cheaper oil and a strong dollar (also resulting in the converse of more expensive exports—cheaper imports) have helped keep ‘bad’ inflation in check.
From an investment perspective, low rates continue to act as a stimulating influence to economic conditions and asset prices. It encourages investor risk-taking, whether it’s moving further out the yield curve in fixed income, to taking more credit risk, cheaper loans for real estate transactions and pushing P/E ratios higher. The consensus view is that interest rates will begin to be normalized somewhat mid-year or in the fall, so status quo expected actions may not move the needle that much. However, more dramatic-than-expected changes in either the magnitude or speed of rate hikes could create more volatility in the short-term (in a variety of asset classes).
Taking a broader view, though, shows the complex nature of interest rate changes. On one hand, they’ve arguably been too low for too long, so a normalization is long overdue. Also, a move in rates higher signifies that the economy is healed enough to function well on its own, which has a positive effect on risk assets such as credit, real estate and equities. If economic growth improves, we may even see some better returns from commodities, but we hate to ask for too much at once.