It has now been ten months since the Federal Reserve achieved “lift off” in December 2015 by raising interest rates for the first time after being at zero since 2009. At that time the FOMC projected four hikes during 2016, with two meetings left before the end of 2016 they are yet to raise rates for a second time. The purpose of this article is simply to highlight some of the factors contributing to the upcoming decisions on the 2nd of November & 14th of December and why we favour December for a 25 basis point hike.
The Fed has an inflation target of 2% as measured by the PCE (personal consumption expenditure) index. The most recent reading covering the year until August 2016 showed that headline inflation expanded at 1% from 0.8% previously, while a core measure that excludes volatile items such as food and energy expanded at 1.7% compared with 1.6% prior. The table below highlights these figures.
Source: http://www.bea.gov/newsreleases/national/pi/pinewsrelease.htm
The next release of this index will be tonight around 11:30pm AEDT. We’ve had numerous comments from Fed officials noting that inflation is now within a whisker of reaching their target, it is important that the Fed does act pre-emptively in order to ensure inflation does not rise too quickly.
The second part of the Fed’s dual mandate is to maintain full employment, which is estimated in the longer-run to range between 4.5-5%. The most recent reading covering the month of August showed a small uptick in the unemployment rate from 4.9% to 5% with the reason for this being an increase in the participation rate from 68.2% to 62.9%, which is an encouraging sign that more people are returning to the workforce.
Throughout 2016 with the exception of an outlier in May, on average 178,000 new jobs have been added each month. This figure is well above the 100,000 that are estimated in order to maintain full employment based on population growth. The next release is scheduled for Friday the 4th of November at 11:30pm AEDT with expectations for an increase of 150,000.
The chart below highlights the unemployment rate which has steadily declined since peaking around 10% in 2009. Arguably one reason behind this is a decline in the participation rate, regardless of this labour market conditions are tightening which we can see in the wage growth discussed below.
As measured by the Federal Reserve Bank of Atlanta, wage growth year-on-year through until September 2016 was +3.6%. The next chart below highlights the increases in wages that are a result of a tightening labour market rising steadily from the February 2010 low of 1.6%
Data on Friday showed that the U.S. economy grew at 2.9% on an annualised basis for the third quarter, surpassing expectations for only 2.6% and up from 1.4% previously. Following a soft start to 2016 growth has been steadily rising and indicators so far are pointing to strong fourth quarter growth as well.
Next we look into what the participants from the FOMC are telling us. The language from Fed officials over the past few months has been clearly preparing the market for a hike later this year and the minutes from the September meeting actually showed how close the call was to not hike rates. During the meeting it was noted that a “substantial majority now viewed the near-term risks to the economic outlook as roughly balanced”. Referring to the recent strength in the labour market the minutes state “it would be appropriate to raise the target range for the federal funds rate relatively soon if the labour market continued to improve”.
In the end the committee agreed that a “reasonable argument could be made either for an increase at this meeting or for waiting for some additional information on the labour market and inflation”. The updated economic projections provided by policy makers at every other meeting also signal that the median projection by the committee expects one rate hike before the end of 2016.
Interestingly at the September meeting three members dissented and voted to increase rates by 25 basis points. Previously it has just been Esther George who had also dissented in July, she is now joined by both Cleveland President Loretta Mester and Boston President Eric Rosengren. This clearly shows momentum shifting towards the more hawkish camp adding weight to the view of a December rate hike.
Importantly members also expressed concern about potential adverse effects on the credibility of the committee if they were to postpone reducing accommodation further. At this point they have prepared the market to expect a December rate hike and postponing this without a significant reason could severely damage market confidence.
The Fed could easily hike at the November 4th meeting if it wanted to however there are a number of key reasons why this is unlikely.
Firstly December gives further time to see evidence of progress in the underlying data, while the recent data has definitely improved it does not suggest any urgent action is required that cannot wait an additional month.
Secondly, another key focus grabbing headlines has been grabbing headlines is the November 8thU.S. Presidential debate. The Fed maintains that it does not make any decisions influenced by politics, however it would ultimately make little sense to hike immediately before a vote which is already causing some uncertainty in the economy and markets.
Thirdly, the market has picked up on all these signals discussed above and is currently pricing in around a 72% chance of a rate hike in December compared with just 8.3% for November. To hike in November would completely catch the market off-guard causing unnecessary volatility and a break down in the communication between the Fed and the market.
Finally, the Fed updates its economic projections every second meeting which is also accompanied by a press conference by Fed Chair Janet Yellen. The November 4th meeting is accompanied by neither and it makes complete sense to wait until the December meeting where Yellen will be able to explain the decision in more detail and provide an updated outlook.
For the reasons mentioned above we believe that pending any unexpected significant shocks to the economy, inflation readings or employment, the FOMC will raise rates by 25 basis points in December. This is mostly factored into the market and is positive sign as the underlying economy is improving.
What will be key moving forward is the path of expected future hikes, the figures provided at the September meeting signal only two hikes are expected in 2017, down from three expected under the June projections. The Fed will remain data dependent, only raising rates when justified by the improvement in the economy, these are expected to be more gradual and peak at lower levels than any time in history. The fact that these hikes will be slower and shallower than previous cycles will continue to provide stimulus to the economy and support risk assets.
