- Expectations for an interest rate hike at the meeting on June 15 of the Federal Open Market Committee (FOMC) quickly evaporated following the weak payroll report published on 3 June 2016.
- Recent events make the June/July interest rate hike debate increasingly controversial.
- A pause at the June meeting would be the fourth sequential meeting without a change since the December interest rate hike.
- Current conditions lead us to question the appropriateness of Fed forecasts, particularly as the span of time between the first and second hike lengthens.
Expectations for an interest rate hike at the forthcoming meeting of the FOMC (on 15 June 2016) quickly evaporated following the weak payroll report released 3 June. Federal Reserve System (Fed) officials had been carefully preparing markets for a potential tightening of monetary policy by categorizing June as a “live” meeting. This disappointing report suggests that the US labor market has softened even after compensating for a strike by workers at Verizon which negatively impacted US payrolls by an estimated 35 thousand jobs in May. Sluggish job gains may warrant continued caution from Fed officials as they debate the appropriateness of monetary policy.
Exhibit 1: A weak number in May 2016 - US non-farm payrolls (month-over-month change) for the period from January 2014 through May 2016
Source: Bloomberg, June 2016.
Recent events make the June/July interest rate hike debate increasingly controversial. Advocates for proceeding with policy tightening tend to focus on the diminishing returns of low interest rate policies and risk of an unintended inflation overshoot. They argue that the economy can withstand another step away from zero interest rate policy. Dissenters declare the global economy as weak and increasingly at risk from US policy divergence. They cite the absence of inflationary pressures as unsupportive of monetary policy tightening. Markets have taken the recent ebb and flow of policy expectations in their stride. We have come a long way since the Bernanke taper tantrum disrupted global markets. Fed communication has improved considerably enabling markets to digest a full cycle of taper along with the first tightening in nearly 10 years with barely a ripple.
A pause at the June meeting would be the fourth sequential meeting without a change since the December 2015 interest rate hike. In previous meetings, the Fed was clearly concerned that global turmoil would negatively impact the US economic recovery. That concern faded as global markets calmed and second quarter domestic data showed signs of firming. Fed officials then strived to ready markets for a potential resumption of the tightening cycle by the June meeting. Recent domestic data, however, fail to support arguments for policy tightening. While market conditions are very similar to the day before the last FOMC meeting in April with equity markets mostly unchanged, credit spreads modestly wider, and the US dollar is slightly weaker, the trend in economic data has deteriorated. Softer labor markets, trendless inflationary pressures, and weaker purchasing manager surveys (ISM) hardly warrant concern of an overheating economy.
In fact, current conditions lead us to question the appropriateness of Fed forecasts, particularly as the span of time between the first and second hike lengthens. Initially, “gradual removal of policy accommodation” was interpreted as meaning roughly every other meeting but that was short lived. The duration of the pause has now been stretched to nearly six months leading many to conclude that Fed forecasts are overly optimistic and inconsistent with the data. Markets have persistently disagreed with the ability of the Fed to normalize policy in the current environment. The gap closed modestly following a marginal reduction in Fed forecasts in March but has once again widened in response to weak data. It will be interesting to see if the Fed’s forecasts have also evolved since the March Summary of Economic Projections and if the gap can persist.
So what metrics are driving Federal Reserve officials to consider another tightening measure? FOMC Chair, Janet Yellen, previously indicated that the key prerequisites were continued progress toward full employment and a reasonable confidence that inflation was trending to target. In the early spring, we learned that international developments were also being considered as relevant. During the last week, several Fed officials indicated that the uncertainty surrounding the Brexit vote in June is also worthy of careful consideration. This broader focus on exogenous factors coupled with softer U.S. data appears to tip the scale in favor of an extended pause as impediments to tightening mount. However, the risk of a policy error cuts both ways. Extreme levels of policy accommodation for extended periods of time may lead to unintended consequences. …stay tuned.