This month it became clear that the Federal Open Market Committee (FOMC) is not too eager to raise rates. This was affirmed by a dovish speech from Fed Chair Janet Yellen during the first week of April. The expectations many market participants held previously, for up to four rate hikes in 2016, has completely faded away.
Yellen’s articulated policy view was affirmed with the release of the March FOMC meeting minutes. And the “no rate rise” story has also been effectively confirmed by economic data that suggest that the U.S., Europe, and China are all simply muddling through. Globally, interest rates are as low as has ever been seen.
Forecasts for U.S. Q1 GDP are below 1%. We can debate if there is a seasonality problem, but the culprits are weaknesses in trade, consumer spending, and inventories. In this light, we find it worrisome that the aggressive monetary policy, witnessed globally, is not delivering. It is providing quantitative easing and, in many places, negative interest rates. But that does not seem to be translating into the desired levels of growth and inflation. In response, central bankers note that their policies have limits and many are encouraging their governments to ramp up deficit spending. The call is for something, anything, to stimulate demand.
If you had just awoken from a Rip Van Winkle-like sleep and were told that the unemployment rate was as low as 5%, you would be amazed that we were complaining about a slow economy and the lack of demand. But the anemic growth rate coupled with a not-so-bad employment rate brings to light how starkly lacking productivity gains have been. Since the end of 2011, real GDP growth has averaged 2.1%, while the unemployment rate has dropped from 8.5% to 5%.
While there are important arguments about how much slack remains in the labor market, the fact is that the Fed’s own forecasts have expected more growth and less employment. The drop in productivity is the surprise element, and also the subject of great debate. Nevertheless, a glaring question at 5% unemployment is if we are close to cost-push levels of unemployment, which could stoke wage inflation.
The possibility of wage inflation in the face of limited growth is a concern on many levels. But we believe it’s a bigger problem when there is an FOMC that has limited interest in tightening monetary policy. For the Fed doves, this is quite the intricate balancing act.
For example, say U.S. economic data improved. We believe it’s likely, the dollar would then strengthen. If that happened, investors would expect emerging markets to sell off again. This could raise flags at the FOMC by heightening the risks to global growth, and perhaps leading the FOMC to strike a cautious tone.
If, instead, the dollar continues to weaken, and with that oil prices continue to rise, we think this could weaken consumer spending as well as negatively impact some of our trading partners. This scenario could also leave the FOMC cautious and concerned about raising rates in the face of higher energy prices dimming demand.
There are, of course, numerous other scenarios, but we think that each could leave the FOMC uncertain. In our view, there is never one “perfect” time to raise rates. With the ever-present constraints of not disrupting global economic conditions and the possibility of exacerbating volatility in global markets, action from the FOMC could be seen as unwelcome. Attempting to avoid aggravating risks or unintended consequences, the FOMC sees itself as hard pressed to raise front-end interest rates again. In this regard, we have gone from Rip Van Winkle to Ground Hog Day: predicting what the FOMC may do is likely to be full of dashed expectations and the same level of frustration we saw last year.
That said, a 5% unemployment rate is likely at or approaching the level below which inflation rises. This probably will present the FOMC with the opportunity to see how much wages can pressure inflation to overshoot the 2% target. This might be what it takes to spur the Fed into action, but do not hold your breath.
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