Fra Fanthom Consulting
Minutes from the June meeting, released this week, revealed that the FOMC was concerned by developments overseas, and wanted to see further improvements in the domestic economy before tightening policy. However, it is important to remember that, at the time of that meeting, all but 2 of the 17 FOMC participants expected to see an increase in the Fed Funds rate by the end of this year. Investors currently see only a 40% chance of a hike by December. Following the initial move, the Fed is expected to proceed at just one quarter of its normal pace. Clearly these are uncertain times. But anyone who anticipates either an agreement that sees Greece remain part of the euro, or a relatively well-contained ‘Grexit’, should in our view prepare themselves for a significant steepening of the US curve.
The minutes of the June Federal Open Market Committee (FOMC) meeting revealed that the committee remained cautious about raising interest rates. Many participants emphasised that “they would need additional information indicating that economic growth was strengthening, that labor market conditions were continuing to improve, and that inflation was moving back toward the Committee’s objective.”
In addition, there were understandable concerns about external factors that could negatively impact on the US economy. Several participants mentioned uncertainty about Greece, and the pace of growth in China and other emerging markets.
However, it is important to remember that this was the same meeting at which 15 of the 17 participants felt that the first policy firming would occur later this year. Many participants expected that labour market underutilisation would be largely eliminated around the year-end. Moreover, as recently highlighted by Fed Vice Chair Stanley Fischer, the Fed “should not wait until [it has] reached [its] objectives” before reacting. Policy needs to be forward looking. Although our central view remains that the first move will be as early as September, it is far from inconceivable that the Committee will choose to wait until December.
In our view, the labour market is already tight enough to justify the beginning of policy normalisation. With payrolls coming in slightly below consensus, many felt that the June labour market data were disappointing. And while the unemployment rate fell from 5.5% to 5.3%, that was driven by a decline in the participation rate. Nevertheless, it is notable that the broader U6 measure of unemployment, which includes people who are marginally attached to the labour force, also fell by 0.3 percentage points to reach its lowest level since July 2008.
The other domestic concern for the Fed is that inflaton remains relatively weak. Core PCE inflation currently stands at just 1.2%, but we judge that there are strong underlying price pressures in the US economy that will push inflation back towards target.
Ask not ‘when?’ but ‘how fast?’
The market-implied path for the Fed Funds rate has for some time been below, and risen less sharply than, the FOMC’s own forecasts.
The timing of the first hike clearly matters, to a degree. Nevertheless, what interests us more is the pace and the extent of the increases that follow. The markets appear to have ruled out entirely the prospect that the Fed might embark on anything close to a normal tightening cycle.
In preparation for our Global Economic and Markets Outlook for 2015 Q3, due to be presented to clients from next week, we have analysed a typical Fed tightening cycle. We find that real rates tend to increase at an average of two percentage points per year, and that the starting point matters. Historically, the lower the starting point the greater the overall adjustment, and the faster the pace of that tightening. With real rates where they are today, the overall adjustment has typically been nearly 400 basis points in real terms, at a pace of around 250 basis points per annum.
We have long been confident about the strength of the US economy. We accept that the global environment, and Europe in particular, is unusually uncertain at present. Nevertheless, we feel it would take a particularly dire outcome for Greece, and for her European neighbours, to justify current market pricing, which sees the real Fed Funds rate rising by little more than 50 basis points per annum. An agreement which saw Greece remain within the single currency area, or even a well-contained ‘Grexit’, should produce a significant tightening in the short-end of the US curve.
