Janet Yellen's Prediction Last Month Is Already Being Vindicated

The Fed will take a pass at this meeting and leave market participants debating whether the first rate hike will come in September or December

Rate Hike: What Do Fed Officials Have in Mind?

The Federal Open Market Committee meets this week to discuss the path of monetary policy.

Any possibility of a rate hike at the meeting’s conclusion on Wednesday was already crushed under the weight of weak data early in the year. To be sure, the data support the transitory nature of the weakness, justifying Federal Reserve Chair Janet Yellen’s optimism last month, but it remains too little, too late. Instead, turn to September as the next opportunity for the first rate hike of this cycle. 

Yellen established her view on the first-quarter data in a May speech:

If confirmed by further estimates, my guess is that this apparent slowdown was largely the result of a variety of transitory factors that occurred at the same time, including the unusually cold and snowy winter and the labor disputes at ports on the West Coast, both of which likely disrupted some economic activity. And some of this apparent weakness may just be statistical noise. I therefore expect the economic data to strengthen.

Recent data suggest Yellen was correct to trust her instincts. Job growth remains steady, with solid reports for both April and May and even tantalizing hints that wage growth is accelerating:

These gains are also evident in the Employment Cost Index:

Continued high levels of job openings in the Job Openings and Labor Turnover Survey (Jolts) bolster the case for stronger wage pressures in the months ahead. Although housing activity remains below prerecession levels, the sector clearly has upward momentum. Inventory for existing homes remains low, prices continue to rise, and the long-beleaguered single-family market is recovering:

Tim Duy

Consequently, builder confidence is regaining the ground lost earlier this year. Separately, auto sales have shown no sign of faltering, continuing to track at prerecession levels:

If the housing and automobile sectors are intact, it is tough to believe that the consumer is in trouble. Indeed, consumer sentiment remains strong.

Also, concerns about underlying consumer strength were largely washed away by the May retail sales report. Looking at the pattern of core sales, it is not even clear what all the fuss was about.

The weak consumer data were particularly disconcerting to Fed officials, especially considering the boost they expected to see from lower energy costs. The May read on consumer spending will thus come as a relief.

Overall, and not surprisingly, given the spate of better news, the now closely followed Atlanta GDP tracker second-quarter estimates are climbing:

Of course, the U.S. economy still has some warts. Notably, manufacturing data continue to be on the soft side. But this reflects, in part, an adjustment in the oil and gas well-drilling industry—the fallout from the sharp decline in oil prices. After that adjustment occurs, the stage will be set for renewed gains in the sector. And note that there is no indication in the forward-looking initial unemployment claims data that this adjustment is working its way through the economy more broadly.

Yellen’s reputation as a top forecaster among Federal Reserve policymakers again appears well deserved. Still, the pace of activity remains moderate, leaving the Fed in no rush to raise interest rates. And improvements come too late for a rate hike at this next meeting. Even St. Louis Federal Reserve President James Bullard, a proponent of hiking rates sooner than later, acquiesced to the data earlier this month:

The data has been weaker and I think that the markets have appropriately moved back the likely date of policy firming.

The ease with which policymakers backed down from a June rate hike speaks to their concerns about the fragility of the economy. They are unwilling to risk undermining the expansion they so carefully helped to nurture, nor do they see pressing reason from inflation data to do so.

They are looking for fairly solid data to put to bed fears raised by first-quarter data and are unlikely to see such in time for a July hike. That puts September in focus.

With no change in rate policy, expect changes to the FOMC statement to be limited to the opening description of the economy. There is a possibility of dissent by Richmond Federal Reserve President Jeffrey Lacker, which might create some news, but which I would interpret as mostly noise. More interesting will be the new set of forecasts from meeting participants. Near-term growth forecasts are likely to be reduced in response to the slow start for the year. Modest downward revisions to inflation forecasts could also be expected.

Given the tendency of the Fed to be positively surprised on unemployment, I think they would be wary of downgrading their forecasts of that indicator. What I am watching more closely is any further downward adjustments to long-run inflation forecasts. Considering recent revisions in March, additional revisions would signal that officials are quickly changing their perspective on the natural rate of unemployment—a development with significant implications for the path of interest rates. The rate projections themselves are likely to be revised modestly downward, particularly in the near term. Indeed, the most aggressive rate forecasts for this year seem to have lost nearly all validity, given the lack of any hikes in the first half of the year.

Yellen’s press conference will be the highlight of the day. The Fed’s statement will likely be interpreted as dovish; be wary that Yellen is subsequently interpreted as hawkish as she will reaffirm the case for a rate hike later this year. She will repeat her conviction that policy needs to be forward looking and thus the time to begin normalizing draws near. But she will also reiterate that the path of policy is data dependent, and the current data and forecasts point to a very gradual increase in rates. Policymakers would like this message to shine through the noise; the more-tradable issue of the first rate hike, however, is likely to remain the dominant focus of market participants.

Bottom Line:  The Fed will take a pass at this meeting and leave market participants debating over September or December as the timing of the first hike. Officals will leave September open, as there is plenty of time between now and then to confirm that the data weakness in the first part of the year was only transitory. Probably not enough time to see this between the June and July meetings. I don’t expect to see news to make me believe that the Fed expects anything but a long, gradual pace of policy normalization. From their perspective, the data have yet to justify anything else.

The author is the professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.

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