Fed Note

Fed Note:

The FOMC decided to raise short-term interest rates by another quarter-percent—the third hike this year—bringing the fed funds target range to 2.00-2.25%.  This was largely as expected, with formal probabilities of such a move being pegged at around 95% based on futures markets.  There were no dissents.

The official statement noted a continued strengthening in economic and labor market activity, in addition to growth both household spending and business fixed investment.  Inflation was described as ‘near target’.  However, the term ‘accommodative’ was removed, in an acknowledgment of the evolution in policy.  The probability of a fourth hike in December by another quarter percent stands at about 75%, while 2019 probabilities are a bit less robust, with an anticipated 2-3 hikes.  However, that’s a lifetime away in the world of data-dependent Fed watching.  Based on assessments of current conditions most closely tracked by the Fed as part of its dual mandate, all are showing a green light:

Economic growth:  GDP growth in the U.S. is expected to remain strong for the third quarter, on the heels of last year’s tax cuts and a pullback in regulation—although concerns over trade and tariff policy, with China particularly, has served as the primary threat to growth.  Where the statistics disagree is on the magnitude, with the New York Fed GDPNowcast predicting an increase of 2.3% for the quarter, and Atlanta Fed GDPNow measure showing a much more robust 4.4% figure.  These are based on real-time inputs that are modeled to be highly correlated to economic activity, which always makes it unusual that the two models can often end up looking as different as they do.

Inflation:  The pace of year-over-year inflation moderated somewhat last month, by about a quarter percent, with the headline CPI number in at 2.7% and core at 2.2%.  The rise in oil prices has been the primary driver of the headline figure, while several recent cross-currents have appeared to keep the core figure in check; however, housing/shelter prices remain a strong contributor.

Employment:  Labor remains the brightest spot of this recovery, with the unemployment rate, jobless claims and job openings all running at multi-decade peaks.  Debate continues about the mythical location of ‘full employment’, whether it’s near the assumed 4.5% area, or at 3.5-4.0% or under, but nonetheless, many of the long-term unemployed have gradually made their way into the job market.  The exceptions are naturally reflective of broader demographic trends such as baby boomer retirements, disability, felony convictions and opioid abuse—each of which appears to be playing at least a contributory role in how ‘full’ employment becomes.  The next item of interest for economists is wage inflation, which has picked up (to 2.9%), although it appears to be affecting selected higher-skill industries for the most part.  If labor markets push tighter, the thought by many economists is that wage inflation will filter through to a greater degree than we’ve seen thus far.

 

The Fed faces an increasing challenge moving forward.  While most economists and other observers are mostly in agreement that the removal of accommodative policies and increasing levels of restriction are appropriate, when is it enough?  The likely answer is the Fed-proclaimed ‘neutral’ rate, which is defined as the ideal balancing rate at which growth is neither encouraged nor discouraged, continues to be estimated at roughly a percent above current fed funds levels.  This is despite gradual Fed movements upwards in keeping with growth in several segments of the economy.  Fed policy has always operated with a lag, so the risk of policy error is two-fold:  that (1) the Fed isn’t moving fast enough in raising rates to keep inflationary impulses in check, and running the risk of growth/inflation ‘getting away from them’; or (2) the pace of interest rate increases is too quick and/or substantial that a ‘policy overshoot’ takes place.  This would result in an over-restrictive policy with rates ending up being too high and perhaps acting as a negative catalyst for economic slowing or even a recession (policy errors like this have happened in the past, so this isn’t a theoretical exercise).  The answer, alluded to by Jerome Powell at the Fed’s Jackson Hole conference recently, is a continued gradual process of raise, then wait and reevaluate—as opposed to the sometimes sharp increases of a half-percent to a percent the Fed has sometimes implemented in the past (granted, when rates were at higher nominal levels).  Thus far, this currently policy has been effective.  But, we’ll only know for sure in hindsight.

Stock and bond markets seem to have priced in the current pace of rate increases, which is at least partially due to the high levels of transparency from the Fed in recent years.  The steadiness of the pace has kept markets from perhaps reacting more dramatically to these higher rates.  At the same time, while bond markets react to sharply higher rates regardless of the reason, for equities, the reason behind higher rates has been much more important.  Thus far, the faster economic and earnings growth has outpaced any concerns over inflation.

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