The Fed Lifts Rates, Not Eyebrows
By Michael Wallace
Anyone secretly longing for a shocker didn't get it from the Federal Open Market Committee, the Federal Reserve's policy-setting arm. The FOMC voted unanimously to lift the Fed funds rate -- what banks charge each other for overnight loans -- by a quarter percentage point, to 1.5%, at its Aug. 10 meeting. The central bank confirmed market expectations with back-to-back moves in both June and August and extended the nascent tightening cycle at least through the summer. The Fed did its level best, however, to acknowledge the erosion of economic vigor, while at the same time signaling that it intends to stay the course on its "measured" tightening strategy.
We at Action Economics expect the central bank will ultimately be vindicated in its view that the recovery remains intact. But the vagaries of the election season, the stock market's weakness, and possible episodes of terrorism pose a material risk that the Fed will pause in its tightening schedule through this fall. Accordingly, we maintain our core view that the Fed will continue tightening by quarter-point increments, to 2.25%, by the end of the year unless given a sufficient excuse to postpone its goal of reaching monetary-policy neutrality.
The balance-of-risks statement remained "roughly equal" with regard to the attainment of sustainable growth and price stability. Moreover, the Fed did not abandon its view that "with underlying inflation still expected to be relatively low, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured." So, the Fed will continue to pack up the accommodative party favors and steadily drain the policy punch bowl, though there is no guarantee that it will not slow down or speed up the process, if warranted.
Most of the Fed's standard rhetoric remained intact in its post-meeting statement, though in light of some of the weak recent economic data, it decided to fine-tune its characterization of the economy. After expressing optimism on output and the labor market back in June, the Fed admitted this time around that "output growth has moderated and the pace of improvement in labor market conditions has slowed." Following the slowdown in second-quarter gross domestic product growth to 3% and the dismal growth in nonfarm payrolls in June and July, it had little alternative.
And the other "elephant in the room" wasn't ignored. After its previous vague reference to "transitory factors" boosting inflation, Alan Greenspan & Co. also confirmed that softness in the economy in recent months owed "importantly to the substantial rise in energy prices." Yet the Fed somehow managed to have its monetary cake and eat it, too, brushing past that economic liability to express optimism about the coming months: The "economy nevertheless appears poised to resume a stronger pace of expansion going forward." That statement was the key to the upbeat reaction by the dollar and stocks on Aug. 10. The bond market, having already rallied in the wake of the payrolls data released Aug. 6, suffered declines.
While acknowledging that the surge in energy prices is a drag on the economy, the Fed was not willing to give too much play to the inflation risks that surge engenders. It stuck doggedly to its view that despite inflation being "somewhat elevated" -- a carbon copy of June's statement -- "a portion of the rise in prices seems to reflect transitory factors." Indeed, the Fed's comfort level with inflation, given tame recent reports on core Consumer Price and Personal Consumption Expenditure indexes, would seem to be high. This will give policymakers the leeway to pause in September or November if the data do not recover from their dizzy spells.
Based on the October contract for Fed funds futures, financial markets are pricing in a 72% chance of a quarter-point hike in September -- up from around 50% after the July payrolls report. The market's less-confident view of the Fed's policy course gives the central bank latitude, for now, to tailor its "measured" approach to next month's round of economic data ahead of its next policy meeting, on Sept. 21.
Wallace is global market strategist for Action Economics