Fed Note 12-14-2016
The probabilities of the Fed taking action at this December meeting were quite high (in the range of 95-100%), and the FOMC didn’t disappoint, raising the target Fed Funds rate to 0.50-0.75%. With strengthening economic data, or at least not weak enough to not proceed, this has been a foregone conclusion for several weeks. There were no dissenting votes at this meeting.
The official statement noted that the economy has been expanding at a ‘moderate’ pace, with gains in labor and household spending, while business fixed investments has remained soft. Inflation increases were also noted, despite levels remaining below the Fed’s target; however, levels are expected to rise as energy price effects trail off and labor improvement finds its way in. Estimates for the ‘dot plot’ of economic growth and inflation both saw slight increases, to the point where three additional rate hikes are implied in 2017; longer-term estimates beyond the next year or two are similarly little changed.
In looking at the mandate dashboard:
Economic growth: The Trump election victory has raised expectations for fiscal spending and stronger sentiment due to plans for lower corporate and personal taxes and a generally more ‘business-friendly’ environment, which includes the potential for a loosening of regulations. This scenario could help push further business capex spending, which is one key area that’s been significantly lacking in this recovery. While the impact of a single election is usually limited, the unleashed ‘animal spirits’ could perpetuate a snowball effect of stronger confidence and spending, which can turn into tangible economic growth effects. At the same time, even policy changes and improved sentiment can’t perform miracles by turning the tide of a secular slower growth tide globally, led by demographics in many cases and fewer ‘easy gains’ from larger developing nations like China, as these evolve into more complex economies.
Inflation: This has ticked upward a bit, which has played a role in market interest rates also moving higher. Much of this is just calendar-based: since CPI and other inflation results are usually measured on a trailing 12-month basis, events like the major oil price decline of the past few years are now rolling off, naturally normalizing base levels. The hoped-for stronger growth has also caused anticipation for a higher-inflation environment as a byproduct, which is not an unusual assumption historically. At the same time, though, there remain deflationary forces globally that could keep this trend from reversing too quickly.
Employment: At the risk of sounding like a broken record, this is the brightest spot in the recovery and is a unique part of the U.S. Fed’s ‘dual mandate’, so is always a critical part of their deliberations. ‘Full’ employment remains a goal, and we’re likely not too far from it, but it is more difficult to get large improvements at this later stage. As much as anything, strength here is a reason for the Fed to pull rates higher.
Over the past year, the path for rate increases has been elongated, with just one each for the past few years (including today’s), and a few expected in 2017 if growth continues as planned. It’s important to note that each year’s beginning forecast has ended up being too optimistic.
Risk markets have experienced a strong run since the election, surprising some people, but has incorporated hopes for stronger economic growth and ‘exit velocity’ (in Fedspeak) out of the current slow growth doldrums. The underlying growth expectations have to actually happen and translate to revenue and earnings for investors to remain content, but this will take quarters and even years to be hashed out. After being lulled to sleep through years of complacency, bond investors have been given a taste of what higher interest rates can mean for supposedly ‘safe’ assets—particularly holders of long-term bonds in the treasury and muni markets who have reached further out on the yield curve for incrementally higher rates while forgetting about the associated risks (whether or not the recent sharp spike in rates proves sustainable). Bonds remain important diversifiers in a portfolio, however, although positioning based on duration/maturity and credit quality has continued to be a big differentiator in returns.