Yellen Still Waiting for Overwhelming Evidence to Warrant Hikeby
Fed’s July meeting will set stage for possible September move
Economic data beat expectations but have less influence on Fed
For Federal Reserve officials, getting better never seems to rise to good enough.
Since the policy-setting Federal Open Market Committee last gathered six weeks ago, economic reports have shown one example of U.S. resilience after another following a slow first quarter. When the monetary policy panel meets on Tuesday and Wednesday, a majority of investors expect them to do what they have done at every meeting this year: nothing.
Indicators such as the June employment report, retail sales, housing starts, capacity utilization, and a gauge of service industries have all beat economists’ expectations. Still, 2016 has defined Chair Janet Yellen’s approach to policy, which might be summed up as a doctrine of waiting for overwhelming evidence.
The strategy is aimed at nursing the economy through the uncertainties of various global shocks while puzzling over head-scratchers that include low productivity and how much support is Fed policy really providing to growth. At the same time, it can seem a highly discretionary, less systematic approach that puts a lot of weight on possible risks that are hard to define or just fade away.
“Upside surprises affect the committee less than downside surprises,” says former Fed governor Laurence Meyer, who now runs a Washington policy analysis firm that bears his name. “There is not a chance that they are going to go at this meeting.”
Investors see only an 8 percent probability of a move being announced when the FOMC releases its policy statement at 2 p.m. on Wednesday, according to pricing in federal funds futures contracts, though recent remarks by policy makers signals that they think the economy remains on track.
There are a host of reasons why Fed officials may feel justified in skipping a rate hike for the fifth straight meeting.
- The Brexit vote was June 23, so U.S. data for last month may not capture the full impact on corporate or consumer sentiment of the U.K.’s decision to quit the European Union. U.S. stocks have recovered their losses since the referendum and advanced on Friday to another record high. But it will still take months, if not years, to understand the full impact of the departure.
- Measures of inflation remain low. The Fed’s preferred inflation benchmark, minus food and energy, rose 1.62 percent for the year ending May. The target is 2 percent for the full index, which is rising at less than half the desired pace due to weak oil prices.
- The committee has only had one jobs report to study since its June 14-15 meeting. True, that reading was strong and suggests the deceleration in hiring from March to May could prove temporary. But with July’s payroll report due on Aug. 5, waiting for more evidence could prove an appealing option.
- Finally, the risks of moving too quickly are asymmetric, as Fed officials noted in the minutes of the June meeting. Their current target range for the benchmark policy rate of 0.25 percent to 0.5 percent is just one cut away from zero. The committee wants to be confident that when it hikes again the economy and inflation won’t falter, forcing it to backtrack.
On the other hand, for the first time since the Fed raised interest rates in December, the chance of an acceleration in growth is looking as real as the downside risks that “several” FOMC participants fretted over in June.
One reason: an unexpected ease in U.S. financial conditions after the Brexit vote is providing the economy with a supporting tailwind.
The Bloomberg index, which takes its readings from spreads on investment-grade, high-yield, and municipal bonds over Treasuries, among other signals, shows financial conditions have eased considerably since the immediate aftermath of the Brexit vote.
The more-favorable credit costs for everything from home mortgages to corporate bonds have been so dramatic that BNP Paribas shifted its projection from no hikes for the next two years to one or possibly two increases in 2016.
“The downside risks have retreated, second-quarter data have been better, and financial conditions have eased,” said Laura Rosner, senior U.S. economist at BNP Paribas in New York. “These conditions will prompt them to start talking about rate hikes.”
As a result, investors will pay close scrutiny to any changes in the language of the statement’s first paragraph, which describes the state of the economy since the last meeting, for hints of a shift.
“They are going to try and do things that make September a live meeting,” said Vincent Reinhart, chief economist at Standish Mellon Asset Management Co. The FOMC will “talk up the data, both in terms of the characterization of the labor market and signal economic momentum has gained better footing.”
However, Reinhart said the committee will reach a compromise and not hike in September as Yellen exercises her preference to allow the economy to run hot. If September is skipped and FOMC participants still forecast one hike in 2016, that’s akin to telling the public that an increase will come at its meeting either in November or December, the ex-Fed official said.