Fra BNP Paribas
What did the June minutes tell us about how the FOMC views the economy and prospects for policy action, and how do they allow us to interpret data since the June meeting? There were a number of key takeaways from the meeting’s minutes: The FOMC discussed risks from Greece not reaching a deal and weak China growth; The FOMC was more upbeat on the labor market, growth and inflation outlooks; and, Those in favor of hiking rates sooner appeared to be patient (or non-voters). June marked the first discussion of whether to raise rates in this cycle. While “some participants viewed the economic conditions for increasing the target range for the fed funds rate as having been met or were confident that they would be met shortly,” just one of these participants appears to be a voting member and was ready to hike rates, but willing to wait “another meeting or two.” Nonetheless, this is a clear move towards a hike, albeit a mild one. Growth
Consumer spending was seen as “somewhat better than previously reported.” Despite weak GDP growth in H1 2015, projections for H2 2015, 2016 and 2017 were largely unchanged. The committee viewed GDP in Q1 as stronger than the official estimate – citing seasonal adjustment issues. “Several” participants reported the services sector was an “area of strength”, with “signs that the [manufacturing] sector was no longer weakening.
Participants thought “labor market conditions had improved somewhat over the intermeeting period.” Most “judged that further progress would be required to eliminate underutilization of labor resources,” while “several” participants indicated that labor market slack had already been eliminated. “Some” anticipate it to be eliminated by the end of the year. For the first time, the Committee acknowledged that it saw a “firming of wage increases.” April’s minutes only cited larger wage gains “in some regions”. Core PCE was viewed to have “firmed recently, signalling some improvement in the inflation outlook.”
Alternative measures of inflation support this view, although they are reliant on a stable currency and oil prices. Policy and financial markets June was the first time in this cycle that a rate hike was formally on the table. Only one voting member was ready to raise rates in June, but this lone hawk does not appear willing to stick his neck out, yet, by dissenting. This tells us that those in the hawkish camp a) are almost entirely non-voters and b) may not yet have high enough conviction to advocate strongly for an earlier lift-off.
Despite the rise in US Treasury yields over the May-June intermeeting period, some participants still were worried about the possibility of an “outsized financial market reaction around the time that policy normalization begins” and “reiterated the importance of effective Committee communications.” The Greek No vote, risk of default in Puerto Rico, the sharp correction in the Chinese stock market and the disappointing June employment report – all of which occurred after the June meeting – are likely to have increased concerns about the financial fall-out from lift-off and are an important factors in our shifting back our call from a September inaugural hike to December, which we feel will receive strong support from domestic data.
The data flow, particularly payrolls, will give the best signal for the timing of the first rate hike. We now see a 30% chance of a September hike; December is our base case. Coming on top of the lacklustre payrolls report on 2 July, September looks like too big a stretch, given market pricing and the Fed’s likely desire to see the rate hike almost fully priced in before it pulls the trigger: there is insufficient runway for a September hike unless there are especially robust data. Of course, the July Humphrey Hawkins testimony and the July FOMC statement and minutes could surprise. But we doubt it. First, the tone for the Humphrey Hawkins will have been set at the June FOMC meeting; we would not expect much departure from the minutes. Second, the overseas financial risks are just too high for the July meeting to tee up a hike. Third, Fed rhetoric is likely to be designed to avoid a Rate Riot, after the Taper Tantrum.
Fed rhetoric will follow the data, not try to lead it. Acting otherwise would not only raise future rate expectations, but would increase uncertainty about the Fed’s future rate intentions. As we saw in 2013, that is the recipe for spiking the term premium. Central banking is supposed to be boring and we are convinced the Fed wants a smooth lift-off, not a bumpy one. Overseas risks will likely play heavily in the 29 July meeting, so we doubt the language will progress much more than inches, if that, towards a rate hike. December is not ideal timing for a rate hike (see Take a hike, Santa?), as market liquidity will be thin. However, waiting until March 2016 is also less-than-ideal, given the likely sub-5% unemployment rate, higher wages and CPI inflation probably above 2%.
Waiting too long would risk hiking too fast, and potentially roiling the markets. If the data and Fed rhetoric lead to the market fully pricing in a December lift-off, an inaugural hike can be delivered then. Will a delay in hiking from September to December cause the Fed to hike more quickly in 2016? We doubt it. There is no unique mapping from the economy to a level of rates. As we’ve seen, there is mapping from the economy to the delta in rates. We continue to foresee five rate hikes in 2016 and one more than before in 2017, with the Fed pausing around mid-year year at 2.5%.
