At the beginning of the year, the March Fed meeting was expected to be one of the four meetings in which there was likely to be an announced rate increase. However, as economic conditions have slowed, credit markets working through stress and global conditions continuing to experience a lack of positive catalysts, probabilities for a move this month fell dramatically to near zero. These guesses turned out to be correct, as nothing was done. Interestingly, Kansas City Fed President Esther George dissented—wanting a rate increase of a quarter percent today.
The committee described the economy growing at a ‘moderate’ pace, noting improvement in household spending and housing, as well as strength in labor, but softer business fixed investment and exports. They did note that ‘global economic global and financial developments continue to pose risks’.
Additionally, the FOMC signaled future intentions, by reducing the number of implied expected increases this year from four to two, lowering the bar for action this year; estimates for GDP growth and inflation were also revised downward for this year. Markets have been ahead of the curve, continuing to price in mixed probabilities—currently 50/50 for a June change. The reality continues to look data-dependent, as the Fed has been hoping for a better domestic and global geopolitical environment as a backdrop for further tightening.
The key metrics as they look today:
Economic growth: Results for Q4 of last year were lackluster, bringing 2015 overall growth to +2.4%—matching the year prior. Expectations for 2016 remain in the lower- to mid-2’s. These estimates, of course, are dependent on a few factors including the strength of the dollar (for which the solid trajectory upward has slowed in recent months, perhaps dampening some of the headwinds for exports), as well as consumer sentiment and manufacturing, which have shown lackluster results in part due to scale-backs in energy investment and uncertainties over global growth prospects. While sometimes underappreciated and difficult to measure, broader uncertainty and/or mixed confidence can dampen enthusiasm for spending by both businesses and consumers creating somewhat of a self-fulfilling prophecy if it goes far enough (and explains why spending momentum/sentiment is so closely tracked).
Inflation: Year-over-year readings on a headline level had been far lower than their long-term average and 2% Fed target levels, with the deflationary impact of plummeting lower energy prices. However, as CPI is a year-over-year relative measure, the extreme drop in oil prices will eventually roll off and lead to normalization. Core prices have already seen a bit of this effect, and are now at levels much closer to the Fed’s target (+2.3% as of this morning). Inflation risk as a ‘problem’ has been almost completely forgotten about in recent quarters, having taken a back seat to greater fears of deflation and stagnation—which have spurred major world central banks to implement extreme easing and even negative interest rate policies. While investors often think of central banks being the primary drivers of interest rate levels (which is true for short-term rates, anyway), longer-term rates further out the yield curve have typically been underpinned by inflation expectations.
Employment: Payrolls have been continuing to improve in recent months, albeit at a slower pace than previously. The marginal rate of improvement has this tendency of moderating when the unemployment rate inches near ‘full’ employment (roughly 5% or so)—where it stands currently. So, improvement may continue, as witnessed by ongoing low levels of jobless claims and improvements in peripheral hiring stats like ‘quit rates’ and the like. Ultimately, policymakers would like to see some wage inflation as a byproduct of this part of the cycle, as a carryover to fundamental growth in other areas, but evidence of this has been sporadic so far. In fact, only a third of industries are seeing wage growth over +3%, which is less dynamic than the Fed would like.
Insofar as investment impacts are concerned, prospects are also becoming more differentiated as central banks around the world have diverged in policy seven years after the global financial crisis. With a backdrop of slow growth, low interest rate policies and yields pegged to them create a fairly unattractive environment for many types of fixed income. This has created the necessity for investors to either move further out to longer maturities in order to capture higher yields, or to delve deeper down the credit spectrum—the latter of which has been made more volatile with uncertainties caused by low energy prices. In the long-term, equity returns are generally guided by dividends, price ratio changes and earnings growth; results in 2016 could likely be driven by hopes improvement in the last of these factors after a mixed 2015.