It was a fairly dramatic turn of events over the prior few weeks with the probabilities of a Fed hike in March moving from about one-in-three or lower to almost guaranteed by the time we heard higher rate-focused comments from several FOMC members—something they often do strategically to help shape expectations. Those expectations were realized this morning with a rate hike of 0.25%, bringing the new Fed funds rate to a range of 0.75-1.00%.
The formal statement acknowledged that economic activity overall has continued to expand at a moderate pace. This is coupled with a strengthening labor market, moderately higher household spending, and increased inflation. The committee’s economic projections, done roughly quarterly, showed little change on net in the areas of GDP growth, unemployment and inflation, although the ‘dot plot’ for upcoming expected interest rate ticked higher, on course for about three rate hikes in 2017 (as already expected).
The change in tune in recent weeks was driven by stronger economic data, firming inflation as well as a realization that several key components of the Fed’s mandate have been reached, including inflation within target and labor market strength. The dashboard of Fed mandates shows this:
Economic growth: Certainly hopes are high with the new administration and expected tax plan and other fiscal stimulus; however, progress on the legislative side has been and could continue to be tougher and take longer than first imagined. Several estimates for Q1 GDP remain tempered, in the 0.5-1.5% or so range, while other ‘real time’ surveys intended to track economic growth with fewer institutional quirks and lags shows growth in a wider range and somewhat higher, primarily due to stronger capex spending from improved business sentiment. Ultimately, though, growth will depend on fundamentals, and sizeable gains are much harder to achieve this late in the business cycle in addition to the continual headwind of challenging demographics that haven’t necessarily turned around.
Inflation: This has firmed—with year-over-year CPI was up +2.7% and +2.2% on a headline level and core, as of this morning for February—with higher commodity prices, a strong housing market (for existing homes and rents) as well as higher healthcare inflation. While near the formal target of 2%, the FOMC has stated a preference for letting things ‘run hot’ to ensure better inflation traction and better insure against any deflationary forces still present.
Employment: The labor market is one of the strongest lynchpins of the FOMC argument for ‘normalizing’ rates. With strong payrolls as of late, jobless claims at multi-decade lows and the unemployment rate hovering near the theoretical place of ‘full’ employment, asking for much better could be challenging from a numbers perspective. There are still job problems out there, but they are not necessarily within the Fed’s mandate (or ability) to solve—including demographic issues such as a semi-permanent cohort of potential workers not employed for reasons of disability, lack of education/training or other factors (including some unique identified factors such as felony convictions, interestingly enough). In this ‘running hot’ mode the Fed is in, headline numbers could continue to improve at a slow rate, but substantial gains still look less likely. The next stop will be looking for deterioration at some point, which could and usually occur at the later innings of the business cycle.
From an investment standpoint, little has changed in terms of themes, but valuations in many risk asset classes have certainly expanded, in keeping with optimism surrounding the new administration. Equity earnings growth has turned positive year-over-year, which is a generally bullish sign for equities, but due to higher multiples, expectations should be kept in check. At the very least, the nearly +20% annualized return over the past eight years after the March 2009 bottom appear less likely, and even +10% per annum return per long-term history could be tougher to achieve. Then again, momentum is a powerful force and assets have to find their way somewhere, which points to optimism for equities over fixed income, where yields remain low (although Fed hikes like this tends to improve them). Volatility is also extremely low, and this is historically unusual as well, so seeing more fluctuations due to Fed speculation and geopolitical developments in the U.S. and abroad, wouldn’t be entirely surprising.