The December FOMC meeting was considered one in the ‘important’ category, in that additional materials were released, a press conference was scheduled afterward, as well as it being the last of the year. Based on economic and inflation data released over the past few weeks, odds of a rate hike had moved to nearly 99%, and the Fed didn’t disappoint. For the third time this year, the rate on fed funds were raised by +0.25% to a new range of 1.25-1.50%.
The formal statement mentioned that the labor market has continued to strengthen, and economic activity has been rising at a ‘solid’ rate. Household spending was described as rising at a ‘moderate’ pace and growth in business fixed investment in recent quarters was acknowledged. The impact of recent hurricanes and rebuilding efforts were noted as impacting economic activity more recently, but not moving the needle dramatically on a national level. Inflation thoughts were mixed, with some gauges running below the 2% target, and others near target. Interestingly, there were dissents from two voters, Evans (Chicago) and Kashkari (Minneapolis), who preferred to keep the rate level unchanged, presumably due to a lack of perceived inflation and growth pressures. Other released materials pointed to three expected hikes next year.
The impact of tax reform is an area FOMC members have been hesitant to address, per their usual attitude toward political events, considering the mixed and changing probabilities for enactment by year-end, not to mention the variety of possible outcomes. However, now that chances of legislative agreement look good, consideration of tax impacts would lead to higher GDP growth expectations and stronger labor markets. Interestingly, despite the Fed’s pace of raising rates, overall financial conditions measured by a variety of inputs have continued to ease—with tighter credit spreads, higher stock prices and a weaker U.S. dollar acting in an accommodative and contrary direction to the Fed.
This was also the final meeting for Chair Janet Yellen. Despite some criticism for being too ‘status quo’, she has been praised by many economists for providing a steady hand and transparency into policy decision-making during a delicate slow-growth post-recession period. As an academic economist, much of her career was spent studying labor market dynamics, and as one of the key Fed mandates, it was no surprise that this was a favorite area of focus. The job of Fed chair can be a thankless one, as one is expected to implement flawless policy at all times and have perfect foresight; but, steering decisions for such a large economy is more akin to a tanker ship than a speedboat. Not ‘crashing the boat’ is also a sign of success, not always achieved.
On to the indicators based on a variety of inputs we monitor:
Economic growth: GDP continues to plug along at a better-than-expected rate. A portion of this growth will be excused as a rebound from the Gulf Coast hurricanes, while other metrics are consistent with a continued slow but steady recovery that has characterized the post-recession business cycle of the past decade. Underlying monthly data has been robust, with ISM numbers in the 50’s for both manufacturing and services, with the index of leading economic indicators continuing to show reasons for optimism. Many concerns at this point are related to the length of the recovery—already one of the longest in history. Ironically, one of the ways to stop a cycle in its tracks, at least historically, has been an over-aggressive Fed.
Inflation: This continues to be a point of debate as much as any other. Inflation-fearing ‘hawkish’ sorts are convinced that a pick-up in CPI is just around the corner, with readings above the Fed’s target likely over the coming several years; the slower-growth ‘dovish’ camp has been steadfast in their assessment that demographic and slower global growth pressures could justify a lower inflation environment for several more years at least (they have been proven right over the last decade as inflation has stayed in the shadows). Fed policy over the coming years will depend on which camp is correct, but little change is expected near-term.
Employment: Labor markets continue to shine as the bright spot in recent years, with unemployment now solidly around or below the ‘full employment’ range; this has been confirmed by ongoing strength in other metrics, such as multi-decade low levels of jobless claims and strong job openings numbers. Recent hurricanes created a blip in those figures, but much of this impact has dissipated. If positive momentum continues, we could see unemployment dip into even lower levels past full employment, which is another indicator implying the economy is running at or beyond full capacity. Underemployment (the ‘U-6’ measure) is already back where it was in 2006, and the overall labor market is now tighter than it was at that time. Anecdotally, it’s been more difficult for employers to find workers for some specialized positions in tech or construction, but overall unemployment rates continue to be stratified by education level, demographics and pace of automation to a degree.
Expectations for Fed activity next year, as usual, are mixed, with 3-4 rate hikes the consensus at this time—implying a pace of one per quarter. At this point, some folks have begun to wonder about the impact of rising rates on risk assets, including bonds most directly, but also how this will impact discount rates on valuations for stocks and real estate. The key is that ‘it depends’. A gradual, widely-expected regime of rate normalization, as has been the case so far, is likely to result in fewer disruptions than the reactionary ‘too late’ method of sharp hikes over a shorter period of time. The former is more supportive of market valuations, and the Fed of recent years appears more cognizant of avoiding the latter, which had been more typical of prior Fed eras and often shocked the system to a much more severe degree and expedited recessions.
This also plays into the current shape of the Treasury yield curve, which has flattened in recent months, with Fed-driven short rates rising and inflation/growth-driven long rates remaining contained. There’s a natural relationship here between current conditions and longer-term expectations, and the flattening has caused some to wonder if the probability of a recession has risen. It’s true that inverted yield curves, where long rates actually fall below short rates, are correlated to higher tendencies of recessions, but a flatter curve has more of a mixed record. Time will tell in this case.