The July FOMC meeting resulted in no action. This was one of those in-between ‘minor’ meetings, with no planned press conference nor any release of economic projections, so no announcements were expected. The official FOMC statement noted continued strength in labor markets (as opposed to last month’s comment about the pace ‘moderating’) and economic activity rising at a moderate rate, while also acknowledging inflation remaining low. There were no dissents.
As it stands, the probability of interest rate moves for upcoming meetings in Sept. through Nov. remain quite low, while Dec. looks to be at about 50/50 at this point. This is not including a likely announcement of balance sheet reductions of Treasury and MBS assets, which could begin in Sept. or Oct., according to current consensus (or ‘relatively soon’ in today’s statement).
Economic growth: The first release of Q2 GDP is expected later this week, and is estimated to be in range of 1.5-2.5%. So, similar to maybe slightly better than Q1, but within recent levels. Early estimates were higher, but sporadic manufacturing numbers and weaker housing than expected have pulled these lower. Hopes persist for fiscal stimulus eventually which could boost growth, but no magic bullet exists currently, with inputs remaining constrained.
Inflation: This has been the area of recent discussion, as CPI and other inflation measures have fallen further below the 2% target level once again. Volatility in petroleum commodity prices has been one culprit, and there’s some blame shared by short-term ‘measurement’ issues such as cell phone data plans, but concerns remain over longer-term structural issues that are keeping levels depressed. Of course, moderate economic growth coupled with reasonably low inflation are not a bad combination. However, the Fed assumes the historical relationship between low inflation and underlying economic stagnation remains a key consideration. (This is especially true considering that the Fed’s mandate doesn’t include making decisions based on levels of economic growth or the pre-emptive ‘popping’ of economic or asset class ‘bubbles’, as has been discussed by some academics—inflation is the only relevant decision variable included under one of the dual mandates.) In fact, there is a group of economists (including current and former FOMC members) that believe current inflation running below target warrants no further rate hike action at this time, and, interestingly, perhaps even more accommodation.
Employment: Labor has remained a source of strength in almost every official metric, including the unemployment rate, JOLTs, jobless claims, etc.—to the point of being near maximum employment. Underneath the headlines, though, lies a less robust story we’ve mentioned before, including a bulk of new jobs created being at the lower services end and related lack of wage growth. This lack of breadth has been troubling to economists and policymakers, hoping for a more traditional situation where wage growth overall accelerates in the latter innings of a business cycle. Instead, this may be as good as it gets, as wage pressures have been relegated to select industries and regions, such as specific construction trades, for example. The downside is that these issues are not easily solved through monetary policy, so remain out of the Fed’s sphere of influence.
Historically, an economic relationship called the Phillips Curve states that as labor markets tighten, wages and other inflation pressures begin to rise, in keeping with broader economic growth. Such an environment would warrant a tightening policy by a central bank. In the current case, though, it represents a conundrum due to the dual mandate the Fed is subjected to: a strong labor market says ‘raise rates,’ while eroding inflation pressures indicate ‘stay put.’ Since there is no graceful method for rectifying the two forces easily, expect more speculation and ‘data dependent’ meetings, although the labor mandate seems to be winning for the time being.
From an economic standpoint, the upcoming planned balance sheet reduction is a positive, implying the economy is strong enough to tolerate such a measure. A key component will be the message—in order to not spook bond markets that too much treasury/mortgage debt will be run off too soon, flooding the market with supply and pushing interest rates higher. Some estimates put the interest rate effect of run-off at a half-percent or so for the coming year, with this having a cumulative effect of up to a few percent over coming years. Due to the sheer size of the Fed’s balance sheet, this will be a long-term effort to say the least. Then again, rates have been forecast for several years to be much higher than they are, so take estimates with a grain of salt.
In the near term, equity markets are sanguine with earnings growth coming in stronger and interest rates relative stable. Volatility has remained low, and is certainly related to this lack of extreme news in either direction. Hope for fiscal policy activity has been pushed out to later this year and into 2018, including tax reform, and some sentiment is certainly tied to success in this area. A continual reminder that investment markets look to the future and not the present, explains the strength this year in foreign markets, areas that have been cheaper and more troubled than the U.S. Despite warnings of complacency, though, momentum can be a powerful force and can keep rallies moving higher and for longer than the naysayers predict.