The January Fed meeting wasn’t expected to be one of any consequence, based on the widely anticipated interest rate move that was handled in December. In their statement, the FOMC acknowledged a slowing of economic growth recently, global financial market volatility, and also pressures that are keeping inflation low, but also labor market improvement. The overall tone of the report was a little more dovish than some expected, which may raise the bar for the next interest rate increase.
The key metrics as they look today:
Economic growth: Estimates for Q4 have been revised downward, putting expected 2015 real GDP growth at the 2.0-2.5% range. While below the long-term average, it’s arguably near the level of current ‘potential’. Expectations for 2016 look to be at a similar pace, although items of recent concern include weaker manufacturing numbers. As a cycle matures, rates of growth will naturally decline, although growth never got that high to begin with in this particular recovery. Bright spots include consumer spending, which continues to be an area of positivity, as are services (which are a much larger component than manufacturing).
Inflation: This is typically measured on a year-over-year basis, so the trailing results are dependent on relative conditions from twelve months ago. Energy price declines happened over a string of months in late 2014 and again in late 2015, causing the most rapid changes in CPI during those periods, while core CPI has stayed in a fairly consistent 1.5-2.0% range for the past several years. This is also concerning to the Fed, since 2% or a bit over-2% levels are needed to reach their policy target, and to feel comfortable about additional tightening. Wage growth has shown some sporadic signs of rising, but it hasn’t been consistent and also varies by job type, as opposed to broader-based movements that have been hoped for.
Employment: This lagging indicator is the one brighter spot in the Fed’s view. After waiting for some time for the jobs picture to improve, unemployment in the 5% area is close to the theoretical level of ‘full employment’ (e.g. where everyone who can be employed generally is, and conditions can’t get markedly better). The unemployment rate could still continue to fall beyond the point of full employment in coming months/quarters, but the economic benefit would be less dramatic. The ‘quality’ of employment continues to be debated, as it has been a continual area of focus in the Presidential race by certain candidates, resonating with a generally positive response.
In short, this was a minor ‘in-between’ meeting, where no major policy shifts were expected. Based on lackluster economic data, the odds of a second rate hike in March have diminished but one is still possible. Factors to be looked at closely between now and then—by both the Fed and asset markets—include oil prices and financial conditions of oil producers; growth conditions and rhetoric from China; as well as the strength of the dollar, which has made life more difficult for U.S. exporters and shaved off fractions of GDP growth as a result.
The pace of Fed interest rates normalization moves higher is expected to be slow and measured. This is probably even more so the case now. The FOMC ‘dot plot’ last month implied 4 rate moves in 2016, while markets feel that’s overly optimistic.
For asset markets, a terrible start to 2016 for equities has lowered valuations and raised expected forward returns. Actual returns will depend, as always, on how growth/earnings as well as conditions abroad compare against very low expectations and mixed sentiment. While U.S. stocks have outperformed foreign in recent years, this relationship tends to vacillate back and forth every few years—foreign stocks now have several tailwinds at their back, including valuation and government stimulus measures abroad. Bonds have performed well as of late from ‘risk off’ flows, but rates are again very low compared to long-term relationships; returns will be dependent on the Fed’s pace of rate hikes, inflation results and safe haven-seeking flows in/out, as few investors appear to be buying government bonds solely due to their extremely attractive long-term yields. Fundamentals in corporate credit are mixed with poor conditions in energy/materials but decent prospects in other areas; this could provide opportunity for less-troubled areas thrown out with the bathwater.