Fed Note

Fed Note:

The June FOMC meeting ended today, and resulted in a +0.25% hike in the fed funds target rate, bringing this to a new range of 1.00-1.25%.  In fact, Fed Funds futures had shown a 99%+ probability of this outcome, which implied a lack of surprise.  There was one dissent, from Minneapolis Fed president Kashkari, who preferred to keep rates at the lower level.

The official statement noted the strong pace of labor markets, despite a moderation in job gains recently, as well as economic activity rising ‘moderately’ this year generally.  Additionally, a reference was made to household and business fixed spending continuing to expand, while inflation declined back below target levels.  Most importantly, perhaps, was the announcement of greater detail surrounding the plan to reduce Fed security holdings (‘the balance sheet’) by decreasing reinvestments.  A specific timeline was not mentioned other than ‘this year’.


Economic growth:  Hopes again are high for stronger Q2 growth, now estimated to be in the mid-3% range, before expectations of it falling back into the familiar low 2’s later this year and next.  The current quarter estimates include some pickup from an especially weak Q1, a tendency that has been the case for the last few years due to weather effects, seasonality distortions and perhaps some mis-measurement factors related to technological change.  Longer-term, growth is dependent on labor force growth and productivity, both of which have been lacking and without any clear fixes, per a variety of economists.  Therefore, exceptional growth above the 2-3% range probably shouldn’t be expected (with or without fiscal influences in the coming year, the likelihood of which remain debatable).

Inflation:  Measures here also remain tempered on a headline and core level, and remain under 2% per this morning’s CPI report.  Economists have been looking for wage growth to jump-start the next stage of cyclical inflation, but this hasn’t happened yet, either, with signs of upward movement in only a few specialized industries.  Long-term inflation concerns remain in some camps, from the perspective of central bank-directed monetary stimulus for so many years and large debt balances, but deflationary impulses elsewhere appear to be keeping this fear contained.

Employment:  Labor markets certainly represent the bright spot in the recovery, with the unemployment rate, JOLTs, jobless claims and other measures showing strength on a multi-year (and multi-decade, for that matter) basis.  The unemployment rate has reached the theoretical level of maximum employment, although conditions may continue push this rate lower—however, if they improve too much, it could result in other imbalances eventually (like surprise wage inflation, which has been a factor historically).  For now, though, strong labor conditions and Chair Yellen’s professional/academic focus on this segment have pushed this mandate to the forefront, as opposed to sporadic strength in other areas, spurring the Fed to tighten.

President Trump reportedly told Yellen he believes her to be a ‘low interest rate person’ like himself, which seems to be a reflection of her dovishness and ongoing accommodativeness of policy, despite calls on the campaign trail that rates needed to be raised.  Due to the potential conflicts with what is politically desired versus what is economically appropriate, the executive branch has purposefully been kept out of monetary policy affairs.  Such independence is one factor that separates central bank activity in developed as opposed to emerging market nations.  The last major intrusion occurred during the late 60s/early 70s in the Nixon administration, that arguably resulted in elevated levels of inflation developing a few years later.

Gradually higher rates appear to be the base case of economists, with several hikes priced in for 2017, not to mention a reduction in the Fed’s balance sheet anticipated later in the year.  The latter action has an implicit tightening effect of its own—rather than buying treasuries/mortgages to depress rates, not buying or outright selling them should have the opposite effect.  As long as this policy tightening is gradual and generally well-communicated, the impact on markets could be contained.  Historically, rate increases due to ‘positive’ forces like economic growth tend to be more positive for markets compared to ‘negative’ issues like inflation, which can turn into a headwind.  S&P earnings growth has been the best it’s been in several years, which is reflected in higher stock valuations.  However, sentiment and money flows have also picked up in Europe and emerging markets, due to signs of better growth and relatively cheaper prices—markets there are in the lead so far in 2017.  This has finally helped more diversified asset allocation portfolios, which have lagged traditional domestically-focused 60/40 positions for the last several years.

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