By Blu Putnam, chief economist, CME Group
The US Federal Reserve appears ready to raise its target federal funds rate for the first time in a decade, even if it is still toying with the markets about timing. Job creation and the unemployment rate are flashing a clear green. Core inflation is still a little below the Fed’s long-term 2% target, but easily within measurement error distance. US 10-year Treasury notes yield above 2%, suggesting a lack of deflation fears. So, why the wait? Why the indecision?
We like the doctor-patient illustration. The Fed seems to view the US economy like a hospital patient that suffered a severe heart attack. The patient was admitted to the intensive care unit back in late 2008. Financial panic was sweeping the globe, with the very messy bankruptcy of Lehman Brothers and the unprecedented and highly unusual bailout of AIG back in September 2008. The patient was admitted to the intensive care unit at the hospital. Emergency treatments, including zero rates and multiple rounds of quantitative easing, were prescribed. As the condition of the patient improved, the QE programs were ended in the fall of 2014. So now the only question is whether the patient is healthy enough to walk out of the hospital without the need of any further emergency measures, such as zero rates.
The Fed, however, is a conservative doctor, in that they do not want to make a mistake and release the patient too early. And, while the vital signs, such as employment are strong, one can always find reasons to worry.
Hourly wages are barely growing and labor participation rates are falling. We think these factors are structural, reflecting an aging economy dealing with the rise of e-commerce, among other factors. The Fed may have some influence over long-term inflation and economic growth, but things like labor participation rates and hourly wages are outside the Fed’s direct influence.
And then, every treatment program has its side-effects. Zero short-term rates penalizes savers, especially retirees. Removing this distortion may even help boost consumption, since with little to no income coming from fixed income portfolios, savings rates have needed to rise for parts of an aging population increasingly worried about retirement. And, the evidence that zero rates and quantitative easing provided much stimulus to the economy remains highly debatable. What has been more evident, however, is that QE and zero rates probably have had their impact on prices of financial assets, including stocks and bonds. That is, continuing the Fed’s emergency policies long after economic growth has resumed runs an increasing danger of encouraging market participants to take on more risk in search of returns than may be prudent.
Taken all together, the Fed finally seems ready to agree to a compromise arrangement between its “hawks” (i.e., those who wanted to abandon zero rates a long time ago) and its “doves” (i.e., those who feel there is little harm in waiting longer). The compromise arrangement seems to be that short-term rates can be pushed higher if the pace is very slow and incremental. Once the first step is taken, the Fed may skip one or two meetings between rate increases, although the 0.25% per step is likely to stay. Also, the Fed does not appear to have any intention of raising rates very high. This time around the Fed might move rates to between 1.5% and 2.0% and simply stop, possibly for a year or more, and watch the inflation and jobs data to see what develops.
Also, we need to ask what the economic and market impact might be of a slow path to slightly higher short-term rates? Unless one has been hiding under a rock, everyone has probably gotten the email that at some point, rates are going up. Such a well-telegraphed decision, even with uncertain timing, probably means that the market reaction will be muted.
Finally, we need to ask what might happen to delay the Fed further.
Greece was a distraction, for sure. The European Central Bank (ECB) was created to manage and protect the single currency. The ECB can probably be relied upon to do whatever it takes to make sure any fallout from a Greek tragedy will not spillover in the EU economy or hurt the Euro.
China is also a risk. The Chinese economy has been decelerating over the last several years, and further deceleration seems likely. Also, the Chinese stock market has been on an impressive roller-coaster ride. There is no sign, however, that the Fed would delay a rate rise decision based on Chinese economic data unless it thought, in the extreme case, that a Chinese recession was coming and it would cause the US to go into recession. This is highly unlikely.
The base case scenario seems to be that the Yellen-Fed is just about ready, possibly in September 2015, to put the legacy emergency policies of the Bernanke-Fed behind it. And if not September, then October or December seem likely candidates.