Fed Note:

The FOMC meeting ended today and resulted in no policy changes, as expected. 

The meeting was a ‘lighter’ version than normal, meaning there wasn’t a Q&A at the end and the other bells and whistles that accompany major meetings (not all Fed meetings have the same formality).  Now, the conversation is focused on what type of rate hike will happen between now and end of 2015.  We know it will probably be a 0.25% increment; we just don’t know if we’ll get one (Sept. or Dec.) or two (Sept . and Dec.).  Odds seem to be tipped in favor of just one at this time.  There’s a Fed meeting in Oct., but, like today, it’s a ‘minor’ meeting with no press conference afterward and no release of new economic/rate projections, so a regime change then is considered unlikely.

In reviewing the dashboard:

Economic growth.  The advance Q2 GDP report will come out just beyond this meeting, but consensus appears to be in the 2.5-3.0% range.  This is higher than recent trend, due to an implied bounceback from exceptional weakness in Q1.  Stats are mixed across the board, though, as areas like retail sales continue to look tempered, and housing is improving somewhat, although in a mixed way.  There isn’t the obvious broad-based spike higher than many have been hoping for.  Economists continue to debate the whys behind the tempered recovery (e.g., it’s still on the way, demographic trends are a hurdle to high growth, technology improvements and productivity aren’t being measured correctly).  It could be several or all of these.

Employment.  The unemployment rate has fallen to the point of near-full employment—the economist nirvana where everyone who is functionally employable has a job.  It’s not quite as simple as this, of course, as labor force participation rates are involved, and baby boomer retirements have been skewing this metric.  Other measures, such as jobless claims, are quite strong, while the late stage components, like wage growth, have only started to show signs.  Per official commentary, the Fed still seems unhappy with where labor conditions are. 

Inflation/monetary stability.  Last year’s oil bust continues to depress year-over-year headline inflation measures, and additional weakness more recently has kept this element in check.  On the less-cyclical core side, rents and implied rents have been rising recently.  All-in-all, these measures remain below the Fed target of 2% and it’s possible they could be willing to sacrifice a little inflation to avoid a slip backward.

In short, market participants expect a rate increase.  This has been baked into expectations for some time; now, it’s a matter of when and by how much.  But the decision isn’t as obvious as some might make it seem.  On one hand, conditions no longer appear to warrant an extremely low ‘emergency’ zero rate, which leaves policymakers little dry powder to combat the inevitable recession at some point.  At the same time, many economists are having a hard time rectifying the lukewarm cyclical recovery with secular structural changes (brought on by technology and demographics) that appear to be dampening long-term growth tendencies relative to past cycles.  Per their own comments, the Fed may take a ‘measured’ approach, perhaps with a quarter-percent increase, followed by a pause, a small increase, a pause, etc., based on how the data looks and impact on markets.  A 1% increase in rates over the course of a year, in quarter-percent intervals, has a very different result than a 1% one-time bump.

Amazingly, we haven’t seen a rate increase in a decade, but these are as much part of the natural economic cycle as accommodative/falling rates.  The natural fear is how stock and bond markets will react to this first rate increase, whenever it arrives.  This has to be the most telegraphed interest rate move in history, especially when compared to the more opaque/secretive moves of FOMCs in the past.  Despite the expectations, a move higher will prove that the Fed’s talk is for real this time, and may result in additional volatility.  But, the ultimate result will come from the pace of the eventual moves—those are expected to be spaced out and moderate—which limits the potential negative impact on risk assets.  In fact, the normalization could even be a confidence booster over time.