Economic Comments

FOMC and the Economy

With the results of last week’s FOMC meeting The Fed continuous to move toward policy neutralization. Slowly. Very slowly. They are exercising extreme patience with the intent to not remove policy accommodation prematurely. Every step is sequenced in the desire to not upset markets. But, they really haven’t changed guidance at all.

Federal Reserve Chair Janet Yellen noted in the associated press conference after the meeting that, no matter how they qualify guidance, the statement does not represent a promise to maintain a particular policy path. Of course, if the statement is not a promise and “considerable period” has no fixed meaning, then the path of policy is strictly data dependent. And that is the idea now emphasized repeatedly by Yellen and Co. If the economy performs better than expected, rate hikes will come sooner and faster than currently anticipated. If worse, the withdrawal of monetary accommodation will be delayed. That seems pretty consistent with the message for the past five years.

Of course, the trick is in one’s interpretation of the data. Is the outlook for the economy really strengthening to 3% growth or better? Or, is the economy going to continue its 2-2.5% flat growth. Is the outlook for the job market improving enough to reach full employment? Or, will the labor force continue to be underutilized? Is the outlook for inflation improved enough to reach the Fed’s 2% target? Which by the way are not just goals, but their mandate.

If one can answer these questions, one can forecast Fed policy. Easy, right, anyone can do it. The Fed itself is forecasting GDP growth of less than 3% and inflation of less than 2% for 2015 with even weaker forecasts for the years 2016 and 2017. Normalization of rates is coming. But again, slowly. Very slowly. They have yet to see sufficient evidence to believe that policy will need to be considerably more aggressive than expected. So why all the discussion between Fed members about the need to raise rates?

And not just discussion, but changes in the Fed’s own forecast. The FOMC’s median rate for the fed funds rate by the end of 2015 was raised to 1.375% from 1.125%, with the key overnight borrowing rate seen reaching 2.875%, rather than 2.50% by the end of 2016.
In contrast, the bond market expects a funds rate of 0.76% by the end of 2015 and 1.82% by the end of 2016, almost a full percent lower than the Fed’s forecast. Why? Could it be that the markets expect lower economic growth than the Fed hopes for?

Because, the Fed doesn’t want market participants to think that the statement represents a promise. It is only a policy expectation dependent on a particular set of assumptions. When those assumptions change, so too will the expectation.

So, does the data support rate hikes? After five long years growth has exceeded 3% in three out of last four quarters, but most of the worlds developed economies – Japan, European Union, UK, China, India and Brazil are all fighting recessions. Will we grow alone? What about current geopolitical events emerging around the globe?

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The labor market is likely to reach full employment in late 2015, but wages are stagnant and labor force participation is at decade lows.

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Inflation is expected to gradually return toward 2% target by late 2016 but with the world’s economies fighting recessions and global supply of commodities plenty capable of meeting current demand. How is inflation going to become a threat to current rates?

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So is the Fed nervous about financial stability, its new quasi mandate? If so, the Kansas City Financial Stress Index (KCFSI) remains well below its historical average of zero; near all-time lows.

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So, I’m not sure where the Fed’s immediacy to raise rates comes from. Economic growth is improving in the US, but is well below long term growth rates. Labor markets are improving, but barely able to keep up with demographic needs and wage pressures are non-existent. Inflation, considering that the world’s central banks are pumping money into the system is barely at target in the US and at risk of deflating everywhere else. Financial stability is a risk, but doesn’t appear to be a current problem requiring attack. With the US economy running below 3% it doesn’t appear it can handle to many shocks, much less one created by the Fed getting policy wrong. No, they will remain very careful with policy.

The outcome of last week’s meeting had little impact on my policy outlook. I continue to expect a rate hike by middle to late next year. Follow the data, just as the Fed is telling you.

Bradley M. Spivey
Vice President