The September Federal Open Market Committee (FOMC) meeting was the first in almost a decade where the agenda included a real possibility of raising interest rates. Given that markets have long expected such an action, it would not have come as a surprise.
2- Year Treasury Constant Maturity Rate (1)
We think growth has been strong enough, with the last GDP reading at 3.7%, and the unemployment rate, now at 5.1%, consistently declining. As the graph above shows, two-year Treasury yields have moved higher in anticipation of a higher Fed Funds Rate. Investors might question: why was this not enough?
In new language added to their statement, the FOMC cited “recent global economic and financial developments” as constraining growth and inflation going forward. In our view, it would seem as though the Fed’s dual goals, to seek both high employment and price stability, include an unwritten corollary: maintaining smooth waters in financial conditions. Given recent market turbulence in currencies, equities, and commodities especially, the FOMC apparently saw no need to throw higher interest rates into the mix. Arguing in their favor, there is an admission that credit conditions have already tightened. The continued appreciation of the U.S. dollar is another component of that. It would appear that overall we have sufficient headwinds without the Fed raising rates.
In short, we think the FOMC is stuck: clearly they see a tighter domestic labor market and, at the same time, cannot get past fears of offshore economic and market factors. Thus, with limited inflation pressures, they do not see a need to take immediate action.
What about Inflation?
A critical question for the FOMC is always whether there is evidence that economic capacity constraints are actually being hit, specifically the kind of constraints that would push through price pressures. This does not appear to be the case.
Instead, we can see that wage growth looks to be limited at best. Given the drop in unemployment, the lack of wage growth is in stark contrast to what we were taught to expect by the economic models that the Fed has traditionally used, the Phillips Curve particularly. This economic model demonstrates the historical inverse relationship between unemployment rates and the inflation rates that typically result under such conditions. Traditionally, an economy with decreased unemployment will witness higher rates of inflation, which is typically driven by wage growth. At present, this does not seem to be a concern in the U.S.
Average Hourly Earnings of Production and Nonsupervisory Employees: Total Private (2)
The Possibility of Doubt
While markets have priced in a Fed Funds increase this year, at the same time, there appears to be limited concerns about inflation. Specifically, Treasury markets have priced in reduced inflation expectations going forward.
5-Year, 5-Year Forward Inflation Expectation Rate (3)
The ‘5-year, 5-year forward inflation expectation rate’ is the Fed’s favorite gauge of inflation. It uses market rates to measure inflation expectations starting five years from now and running five years from that date, telling us roughly what financial markets think inflation will be in five years.
Obviously, overshooting inflation is towards the bottom of market concerns. The data just is not there to suggest that inflation should be a concern. Core CPI has risen 1.8% over the last year; the overall measure is up just 0.2%. Increases in employment have not pushed up prices as the models anticipated. Perhaps the FOMC’s failure to raise the Fed Funds target rate is an admission that for the Fed to trust in models that say inflationary forces are soon to break out might be to misplace trust in those models? This kind of Phillips Curve mentality has simply not been accurate.
Therefore, we view the FOMC action today as a likely message that they would rather see actual inflation data than anticipate it based on an imprecise model.
(2) FRED, shaded areas indicate U.S. recessions
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