No policy action was taken at today’s Federal Open Market Committee meeting, which was the unanimously expected result. The FOMC statement acknowledged stronger labor activity and housing, while also the negatives of slowing general economic growth as well as continued weak business capex spending and exports. However, the committee expects a longer-term shift back to growth at a ‘moderate’ pace. The vote was 9-1, with KC Fed President Esther George dissenting in favor of a quarter-point increase in rates (as she did in March as well). This was a ‘minor’ meeting with no press conference scheduled, so there is less to comment on than usual.
As for the key metrics:
Economic growth: For Q1 that just ended, expectations have fallen to 0.5-1.0%, while estimates for 2016, as well as the next several years, have declined to the 1.5-2.0% range. Rare is it for one to see a prediction of a recession from an economist outright (not to mention the timing being tricky), but as a business cycle matures, the risk of one happening does increase from the long-term baseline of 20-25% for any given year that is the case regardless of conditions. A slow growth environment exacerbates such fears, as there is a thinner buffer of activity to keep the economy moving at faster than ‘stall speed’. On the other side, though, many excesses that characterize economic cycle peaks, such as high corporate capex spending, high leverage and generally exuberant sentiment, do not appear to have materialized. This could lengthen the current cycle.
Inflation: As we discussed in the Question of the Week recently, inflation is a double-edged sword, with low inflation a positive to some extent from the consumer and business spending side, but also tends to be the byproduct of slow growth, which is a global phenomenon as of late. This mirrors the dichotomy faced by cheap crude oil in terms of it creating a complicated mix of benefits and challenges. Headline CPI remains below 1% on a year-over-year basis, and core CPI, without the influence of food or energy, is just above 2%. The latter is not far from the Fed’s target, but the rolling 12-month pace of change will make inflation a moving target this year.
Employment: Based on a variety of metrics, labor indicators are strong, and arguably, perhaps at the best levels possible for this cycle. Recent results for the unemployment rate, nonfarm payrolls, weekly claims and, as of late, improving labor force participation, point to conditions near ‘full’ employment. This is the theoretical and magical place where nearly everyone who wants a job has one, and further improvement is harder to come by (although it could still occur for a while). Whenever conditions reach such a level and plateau, the question evolves to ‘what’s next?’ This includes looking at the rate of change on the opposite site—should employment begin to show signs of weakening, that might point to heightened recessionary risks, which could naturally affect Fed sentiment and policy (even if such fears are a ways off).
The Fed likely wishes they had more ammo in the form of higher rates that could be lowered again to combat a downturn when it ultimately comes. Markets and economists have downgraded the possibility of Fed rate hikes this year from an original 4 down to 1-2 (if that), at this current pace of extremely tempered growth. Expectations for ‘surprise’ growth or inflation remain low, but are always possible, and such data could affect market interest rate reactions at various parts of the yield curve. The dollar has also weakened a bit, which is a positive for exporting activity and, if sustained, could assist in improving earnings for U.S. blue chip companies.
Earlier in the year, markets remained more troubled by the possibility of negative rates, which at face value, seem nonsensical, but have actually now occurred in Europe and Japan. While U.S. growth is more robust (in relative terms) than in those areas, no one seems ready to pull the idea off the table, despite more complexities here than elsewhere (not the least of which are robust commercial paper markets and natural buyers of said paper—money market mutual funds—for which negative rates could cause major capital liquidity bottlenecks). Equities appear fairly valued again, with forward-looking returns largely dependent on earnings growth prospects moving forward—in relative terms, though, stocks continue to offer brighter prospects than the lowest-yielding segments of fixed income. With stronger recovery potential and better valuations, international equities continue to offer compelling potential, especially after several years of being out of favor.