The Federal Open Market Committee (FOMC) left the Fed Funds rate unchanged at 0.25-0.50% at its most recent meeting on November 2nd. In its statement the FOMC pointed to increases in actual and market-based measures of inflation and a strengthening labor market to support their decision. However, the “committee judges that the case for an increase in the federal funds rate has continued to strengthened…” This is important as the FOMC has been sensitive to inflation running well below its inflation target of 2%. Last Friday’s non-farm payroll of 147,000, pushing the unemployment rate to 4.9%, which should not throw the Fed off its path to raise rates at the December 14th meeting for the first time this year. The market currently is pricing in 82% probability for a December rate hike, up from a 48% in September.
The FOMC has been overly concerned that an early rise in rates could impede progress on the economy and the financial markets. History shows that central banks that raise rates too soon have hampered economic growth.
A few of the headwinds that have been holding back the decision to raise rates have been abating. Inflation is moving up as wages have been slowly increasing, import prices have been rising, and the dollar weakening. Political uncertainty will start to clear up tomorrow and by the time the FOMC meets in December the market will have priced in a new administration. Foreign Central Banks have continued easing monetary policies. The Bank of Japan and the European Central bank continue to have cumulative asset purchases of $200bn every month. However, recently the BoJ surprised investors replacing a policy of negative rates with one more targeting the yield curve. This new policy initiative will help keep the curve “steep”, aiding Japan’s banking system.
The FOMC is running out of time to raise rates as the economy moves through the investment cycle. If the economy does start to falter the Fed will have less “ammunition” to fight a recession. Fed Chairwoman, Janet Yellen, in her speech at Jackson Hole(1) in August mentioned that the FOMC has on average, reduced rates by about 5.50% when dealing with an average recession. She continued to say that it is a simple comparison. I do agree with her that this is a fairly simple statement but it does bring to the question how much could the FOMC fight a slowing economy if rates are at 1%? Or even 2.5%?
The Fed is challenged to accurately time future rate hikes. If they are too quick they could stump the economy or if not quick enough to maintain flexibility to fight the next economic slowdown.
APCM’s view is that the FOMC will raise rates in December. They will continue to be data dependent and aware of global implications of exogenous shocks to the financial system. As the calendar turns to 2017 we expect the Fed will be cautious to increase rates.
Bill Lierman, CFA®
Chief Investment Officer, Fixed Income
(1) Yellen, Janet L. “The Federal Reserve’s Monetary Policy Toolkit: Past, Present, and Future” Symposium Sponsored by the Federal Reserve Bank of Kansas City. Jackson Hole, Wyoming, 26th 2016. Speech