The FOMC has five meetings left this year to decide to raise rates or keep them stubbornly low. At the beginning of the year the market was very optimistic and forecasted the Fed raising rates up to four times leaving the Fed Funds rates between 1.00-1.25%. APCM was less optimistic with a forecast of two rate hikes. Our assumption had more to do with what the Fed said than with the Fed’s statutory mandates of employment and inflation. APCM believes that 1-2 rate hikes are a probability this year with the earliest being at the July meeting.
Chairwoman Janet Yellen has consistently been on record in her speeches and testimony to congress that rate rises will be slow, gradual, and well communicated to the markets. She argues the pace of rate hikes are more important to the stability of the economy than the size or the terminal rate. We concur with this thought as an aggressive set of rate hikes could have unintended consequences.
Let’s look at four factors that are helping to shape our view for a gradual increase in rates.
First, unemployment is running at 5.0%. The labor market is in relatively good shape. Initial jobless claims have been at historical lows while the service sector of the U.S. economy has continued to show strength.
Second, headline CPI inflation year-over-year registered 1.1% in April well below the 2% targeted by the Fed. If we strip out the volatile nature of food and energy (20% of the index) and look at the core inflation, it was 2.1%. Energy prices have seemed to have found a bottom as oil prices are in the mid $40’s compared to a low of $26 in February. As the year continues the negative inflation prints due to the decline in energy prices will subside and rising oil prices will be accretive to the CPI allowing the Fed to feel comfortable to raise rates.
Third, the strength in the dollar which affects inflation through import prices is in a range that is consistent with the Fed’s last hike. Currently the DXY index, an average of exchange rates between the US dollar and other major world currencies, is at 94.61. The DXY index was stronger in December when the Fed raised rates for the first time.
Janet Yellen in a speech in September 2015(1) on Inflation Dynamics and Monetary Policy added more insight on how the Fed looks at inflation and the strength of the dollar as she said, “the 12-month change in total PCE prices is likely to rebound to 1-1/2 percent or higher in 2016, barring a further substantial drop in crude oil prices and provided that the dollar does not appreciate noticeable further”. Today, oil prices have increased and the dollar is actually weaker. If the modeling done by the Fed is accurate we should start to see an increase in PCE (the Fed’s preferred inflation gauge) from its current year-over-year 0.8%.
Fourth, global events that will affect the U.S. economy. The FOMC somewhat surprised the markets at its September 17, 2015 meeting by not rising rates and mentioning that one reason is its “monitoring developments abroad”. This on the back of Janet Yellen’s comments on July 15th 2015 to congress that recent turmoil in Europe and China would not bleed over to the U.S economy. The quick change in thought from the FOMC brought instability to the rate market in September as the two-year Treasury rated declined from 0.81% at the September meeting to 0.55% in one month. The market and the Fed were not “on the same page”.
The unexpected turmoil both in Europe and China have calmed and the market has now priced in slower growth prospects. There is a chance the markets can be turbulent around June 23rd as Britain votes to leave the European Union or not. Once this date has passed there should be an environment of satisfactory labor conditions, higher actual and expected inflation and a steady US dollar that will allow the Fed to raise rates 1-2 more times.
Bill Lierman, CFA®
Vice President, Portfolio Manager
- Yellen, Janet L. (2015). “Inflation Dynamics and Monetary Policy,” lectured delivered at The Philip Gamble Memorial Lecture sponsored by University of Massachusetts, Amherst., September 24th.