Not June, Not Likely July, More Likely September

The Fed's been stripped of an opportunity.

The One Thing the Fed Should Say, but Doesn't

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.

The best-laid plans can come undone by the tiniest of things.

In this case a slip in the data—a low print on nonfarm payrolls that may prove no more than a statistical bump—put a June interest rate hike out of reach for the Federal Reserve and probably a July one as well. That leaves September in focus as the next chance for the U.S. central bank to tighten policy—if the data hold.

Back in April, I predicted the Fed would want to increase the uncertainty surrounding the June meeting. That it did, responding to complacent market participants expecting the Fed to take a pass on June with a barrage of "Fedspeak" that placed the month clearly on the table. See, for example, comments by Federal Reserve Bank of San Francisco Presidents John Williams and Atlanta Fed Presedient Dennis Lockhart. The minutes of the April meeting arrived on the heels of these comments and erased any doubt that Federal Open Market Committee participants considered a June rate hike a real possibility:

"Participants agreed that their ongoing assessments of the data and other incoming information, as well as the implications for the outlook, would determine the timing and pace of future adjustments to the stance of monetary policy. Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee's 2 percent objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June."

That data had looked to be supporting that view as GDP tracking numbers signal a rebound in second-quarter growth after a dismal first-quarter outcome:

Source: Bloomberg

But then came the May employment report. Job gains of 38,000 were low even after accounting for a strike at Verizon Communications Inc. that cut 35,000 jobs from the telecommunications sector, and previous months were also revised downward. Slowing output growth appears to have caught up with what had been resilient labor markets, leaving in doubt the continued progress on reaching the Fed's full employment mandate. A June rate hike abruptly fell off the table with the futures market now indicating a zero percent chance of an increase in June, according to Bloomberg data.

Where does that leave us now?

Note that the Fed retains a fundamentally optimistic economic outlook.

This was particularly apparent in Federal Reserve Chair Janet Yellen's speech last week:

"My message will be largely favorable, although recent developments have been mixed. Most importantly, the economy has registered considerable progress over the past several years toward the Federal Reserve's goals of maximum employment and price stability, and, as I will explain, there are good reasons to expect that we will advance further toward those goals. … If incoming data are consistent with labor market conditions strengthening and inflation making progress toward our 2 percent objective, as I expect, further gradual increases in the federal funds rate are likely to be appropriate and most conducive to meeting and maintaining those objectives."

Yellen also urged caution in reading too much into the May employment numbers:

"Although this recent labor market report was, on balance, concerning, let me emphasize that one should never attach too much significance to any single monthly report. Other timely indicators from the labor market have been more positive."

Yellen's thinking is fairly consistent with the baseline view among FOMC participants: The first-quarter data were mostly a temporary setback, as evidenced by improving second-quarter numbers, and thus underlying growth remains sufficient to drive further improvement in the labor market. With unemployment now at levels consistent with most estimates of full employment, the economy is nearing a point that inflationary pressures will emerge. Indeed, three of the last four readings on core-PCE inflation have been greater than 2 percent annualized. Given that the Fed wants to both continue to raise rates only gradually and hit its inflation target from below, it expects a need to hike rates in the near future. That's what keeps hikes on the table.

But this month, it turns out, is too near. Yellen has some unanswered questions to be resolved before another rate hike. As she framed it:

"Over the past few months, financial conditions have recovered significantly and many of the risks from abroad have diminished, although some risks remain. In addition, consumer spending appears to have rebounded, providing some reassurance that overall growth has indeed picked up as expected. Unfortunately, as I noted earlier, new questions about the economic outlook have been raised by the recent labor market data. Is the markedly reduced pace of hiring in April and May a harbinger of a persistent slowdown in the broader economy? Or will monthly payroll gains move up toward the solid pace they maintained earlier this year and in 2015? Does the latest reading on the unemployment rate indicate that we are essentially back to full employment, or does relatively subdued wage growth signal that more slack remains? My colleagues and I will be wrestling with these and other related questions going forward."

It is possible that these questions are answered in time for the July meeting—possible, but doubtful. Maybe, if incoming data remain consistent with the Fed's forecast of steady, somewhat above-trend growth, and the June employment report comes in strong with substantial upward revisions for May, the stars might align for a July hike. That's possible, with nontrivial odds, but still less than 50 percent at this point. Look toward September instead.

Altogether then, the Fed will stand pat on rates this week. Expect the FOMC statement to highlight a rebound in consumer spending but be tempered by mixed employment readings. The Fed will see the housing sector as still strong but business investment as still weak. The story on inflation will also remain the same—low market-based measures of expectations contrasted with stable survey-based measures. Arguably, the June decline in University of Michigan long-run inflation expectations to a record low of 2.3 percent could prompt the central bank to abandon this assessment. But that would be dovish and take rate hikes off the table for the rest of the year. The Fed isn’t ready to go there just yet.

It will be hard to bring about an agreement on the assessment of risks. Some participants will argue against placing too much focus on the last employment report, claiming instead that the totality of data continues to tell a positive story. Others will not be swayed by this argument. Importantly, Federal Reserve Governor Lael Brainard said after the employment report that "recent economic developments have been mixed, and important downside risks remain." She will resist a balanced assessment, and others would follow. Hence, I expect the Fed will decline to assess the balance of risks. This has the advantage of not tipping its hand either way with regard to July.

The Fed will also release its latest Summary of Economic projections. Participants may edge down the growth expectations to reflect the weak first quarter numbers—although this depends on how much they have marked up second-quarter forecasts—while the unemployment forecast is also brought down (it currently stands at 4.7 percent for yearend 2016, a level hit in May). I suspect inflation projections will be little changed. The median expectations for two more rate hikes this year—think September and December—will hold, but the top dots will fall. Watch also for a somewhat shallower path of rate increases in the future, driven by increasing pessimism over the end game, the long-run natural rate.

The FOMC statement will be followed by a press conference. There Yellen will steer a middle ground between optimism and pessimism. Keeping a July hike in play will be her primary objective. With even her believing the economy is near full employment, the Fed will not yet give up on the story that an economic bounce in the second quarter will be sufficient to justify a rate hike in July.

Bottom Line: The optimistic tale spun by Yellen tells us that the Fed is ready and willing to hike rates. But that pesky little detail of a consistent data narrative to justify such a move continues to elude policymakers. The lack of supportive data has stripped them of a chance to hike rates in June, and also leaves July as an unlikely candidate. Turn your eyes to September.

(Corrects spelling of Federal Reserve Governor Lael Brainard's name in 18th paragraph.)
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