The June FOMC meeting concluded with members deciding to raise the fed funds target rate by 0.25%, for the seventh time this cycle, to a new range of 1.75-2.00%. As the probability of this happening was over 95%, in light of recent stronger economic and inflation data, this was far from a surprise.
The formal statement noted the recent strength in economic activity, upgrading their description from ‘moderate’ to ‘solid’, as well as mentioning a pickup in household spending and continuation of business spending growth. Long-term inflation expectations were described as ‘little changed’. Language regarding their policy expectations was simplified somewhat, but the same theme of ‘gradual’ rate increases noted in keeping with signs of positivity in key economic growth metrics. The word ‘symmetric’ was again included as describing their inflation objective, with the implied meaning that 2% isn’t a hard target, but inflation could likely be allowed to float above and below that bound as needed in light of other policy aims. No doubt there will be ample economist commentary on that component, as there already has. Events in foreign markets were expected to make a cameo appearance in their write-up, particularly geopolitical rumblings in Italy and Spain in recent weeks, as a reflection of how such events can play into financial market volatility, even though they have no bearing on U.S. monetary policy functions directly—although today’s piece excluded any such references.
While this second hike of 2018 was expected, future moves are always ‘data dependent’. Currently, the September meeting is assumed to result in another quarter-point move, while December is about 50/50—in keeping with continued debate between the ‘3 hike’ and ‘4 hike’ camps this year. With such small rate hike increments, individual meetings may not be that critical, but over time, the impact of rate increases is cumulative.
The metrics are little changed, with similar themes and trends continuing:
Economic growth: GDP for the first quarter came in a bit lower than expectations, similar to other weak Q1’s in recent years with perhaps ongoing adjustment difficulties, while Q2 GDP estimates are pointing to a surge into the mid- to upper 3’s. Predictions of similar magnitude in prior quarters were pared back as time rolled on, so this early high growth call has been taken with some degree of skepticism. While business tax cuts and stronger confidence have been positive catalysts for additional capex spending, it’s possible this could be restrained compared to what might have occurred earlier in the business cycle when the return-for-risk tradeoff looked more attractive than it does today.
Inflation: Through May, consumer price inflation rose 2.8% on a year-over-year basis, due to a sharp increase in the price of crude oil. Core CPI is also higher, at 2.2%, due to carry-through effects from energy as well as higher inflation in shelter and services. Wage inflation ticked up again to 2.7%, which created some cause for concern (again), with economists and others scratching their heads over the missing Phillips Curve tendency for low unemployment and inflation to occur together (in reality, they don’t always do so).
Employment: This remains the strongest bullet point, with labor metrics continuing to fire on all cylinders. The unemployment rate fell to 3.8%—the lowest level since 1969—which surpassed the lows of more recent troughs in 2007 and 2000. Job openings continue to run at a high level, while jobless claims levels also remain extraordinarily low, implying minimal layoff activity. There is some expectation for the unemployment rate to continue to decline toward the mid 3’s, which has only occurred in the late 1960’s and early 1950’s (the data series began just after World War II).
It does seem that FOMC sentiment has tilted a bit toward the hawkish side, due to the composition of the voting membership, but also from strength in employment and growth metrics, although the allowed pace of inflation remains an element of debate. While the rate hike pace remains true to their promise of ‘gradual’, many are looking now towards a possible ending point—where the emergence of a recession would naturally put a pause in the Fed’s plans, and begin a reversal towards accommodative policy once again. A recession doesn’t appear imminent, though, based on a variety of economist models. The endpoint has also been discussed in various speeches and papers by several FOMC members, in attempts to determine the current ideal or ‘neutral’ real fed funds rate, when all factors are in balance (a rate known as ‘R-star’ or R* in formulaic terms). This real fed funds rate has been substantially lower than during most of history, and debate continues about whether the Fed will continue to press on to push this rate higher at a faster pace than usual to get it back to the ‘normal’ level it should be. The difficult part is that no one agrees at what level this rate actually resides, as it’s more of a theoretical construct. It’s important to remember that everything the Fed does is partially based on economic theory and part in practical reality.
At what point do higher rates begin to act as a disruption to investment markets? There is no one magic number, but a few economists have thrown out the upper 3’s or lower 4’s on the 10-year treasury as a possible tipping point for a more meaningful impact. Much more importantly, though, is the impetus behind rising rates—stronger economic growth is seen as a ‘good’ reason, with the assumption being that byproducts of growth will offset the rate impact, and inflation-fighting rate hikes are ‘bad’. While extreme economic improvement is less likely at this point, momentum can be persistent, and this current trend of growth may continue to run at a high level. What to watch for? Credit excesses are a common attribute of late cycles, as growth gets harder to come by and defaults remain low, which keeps lenders and investors complacent. Inflation, of course, has crept up in past late cycles so many are watching for this again. Some have been looking for inflation since the financial crisis, and some look for it constantly. However, it’s interesting to note that, per Deutsche Bank, since 1800, the U.S. inflation rate has run below 1.5% on average (higher in wars and during the 1970’s period, and far lower during peacetime).
Aside from recent trade/tariff disruptions and a political environment overseas that brought up questions of commitment to the euro, conditions are generally benign. Earnings growth has translated to higher stock prices, while credit appears to be the preferred location for many in fixed income—although higher rates have tipped the balance a bit towards treasuries. Even commodities have emerged from the doghouse to leading asset class for the year.
Less obvious beneficiaries of recent Fed policy are cash investors, who have seen rates in savings accounts and money market funds move from practically zero to far more respectable levels pushing 2%. While still underperforming inflation (as they’re frequently apt to do over time), at least the race is a bit closer now and the opportunity cost of cash is less of a penalty. Should risk assets continue to scream along and valuations become more stretched as the cycle progresses, eventually this cash ‘dry powder’ may become quite coveted, indeed.