Currently, the central question for Fed Watchers is whether the economic troubles in China and the stock market downdraft of August 2015 will influence the Federal Reserve (Fed) to delay an increase in its target federal funds rate. We think not, and still look to the September 2015 Federal Open Market Committee (FOMC) meeting as the most likely time for the first rate rise in a decade. Here’s why.
The Fed does not own stocks. The Fed only worries about stock market downdrafts when there is systematic risk to the financial system, such as in October 1987 or September 2008, when large financial institutions might have failed and brought down the whole economy. The Fed often worries about stock prices being too high (remember Alan Greenspan’s “exuberance” comment during the 1990s tech rally). Indeed, the Fed probably views this current market correction as a healthy pause that refreshes, since the Fed’s own zero-rate and Quantitative Easing (QE) policies have likely pushed investors to aggressively search for yield, possibly leading to excessive risk-taking.
...we still expect the Fed to initiate the first rate-rise in the federal funds rate in over a decade at the September FOMC meeting, although we would put our qualitative probability assessment at only around 55%.The Fed watches China as we all do. The Fed is mainly concerned, however, with whether economic troubles in China could cause a US recession. The Fed is not concerned about whether a stock market that has gone up over 100% comes down 50%. Moreover, China’s economic woes are largely due to the fact that the customers for its exports are hardly growing any more. Brazil’s economy is stagnant. Mexico is growing only slowly. Europe may post all of 1.5% real GDP growth this year after three years of modest decline. The US is on track for 2.5% real GDP growth. Japan is not growing. China could devalue the RMB by 30% and exports would barely increase given the modest growth prospects of its customers. As in almost any business, customers’ incomes are primary to price when assessing sales prospects. And taking the long view, China was an engine of growth for three decades, 1980-2010, growing at about 10% real GDP on average over this period. As China has successfully modernized, it has also seen its demographics shift into an aging pattern, and it is only natural that real GDP growth would converge to a slower pace consistent with an aging, modernized, mature industrial economy.
So, we do not think the troubles in China or the recent stock market decline will cause the Fed to delay its decision. Moreover, we think there are important reasons that the Fed is ready to make its move.
There is a strong sense that the Yellen-Fed would like to put the Bernanke era of emergency policy measures behind it. Yellen has reformed forward-guidance and abandoned Bernanke’s fixation on the unemployment rate. The Yellen-Fed is highly data dependent, but it is the whole picture that matters, not any one or two indicators.
Yellen has ended QE. The evidence that QE lowered bond yields is compelling, but the evidence that lower bond yields help create any jobs or spur economic growth is highly controversial and disputed by many analysts (including myself). Indeed, the main impact of zero-rates and QE may well have been to support asset prices and push them to unsustainable levels, instead of having any material impact on economic growth or job creation.
The bottom-line for a data-dependent Fed is that the US economy is creating over 200,000 net new jobs a month on a consistent basis, the housing market (which was at the epicenter of the 2008-2009 recession) is healthy and growing, and while real GDP growth is not above 3% as many had hoped, the US economy has been a rock of steady growth in the 2%-2.5% territory since the end of 2009. That is, we have posted almost six years of consistent real GDP growth and job creation. Does the US economy still need emergency policies? No.
There are risks, however, to consider and they weigh against any aggressive moves. US inflation is between 1% and 2%, where it has been since 1994. Sustained low inflation is a good omen for steady longer-term growth, just so long as the low inflation does not slip into deflation. Because of the weakness in global commodity prices, partly due to supply increases, and slower economic growth in China and other emerging market countries, there is some downward pressure on consumer prices. But the US does not seem at risk of deflation, especially if one focuses, as the Fed does, on core inflation that removes the more volatile food and energy components.
In summary, we still expect the Fed to initiate the first rate-rise in the federal funds rate in over a decade at the September FOMC meeting, although we would put our qualitative probability assessment at only around 55%, with a 30% probability for action later in the year, and 15% probability of the decision being delayed into 2016. The markets, as represented by federal funds futures, have a much lower probability attached to the September FOMC meeting.
When the rate-rise move comes, it is likely to be the first of several. However, the Fed may make it clear that it will go slow and skip meetings in between rate rises.
The Fed may even surprise us by abandoning ranges and reverting back to its old habit of simply setting an explicit point target for the effective federal funds rate. And, to add to the surprise, the Fed might choose 0.25% as the new target for the effective federal funds rate, instead of moving to a 0.25% to 0.50% range.
As a final note of caution, we would point out that the US employment report due for release on 4th September is still a critical data point. We estimate job creation at 225,000 per month or higher. Nevertheless, if for any reason, the jobs data surprises to the downside, say less than 200,000 net new jobs created, then the Fed might delay its rate-rise decision past the September FOMC meeting. The bigger the downward surprise the longer the delay, as more data points will be needed to confirm whether the unexpected downward movement was a blip or a new and weaker trend. For this reason, we feel that if the jobs number is unexpectedly weak, then the October FOMC meeting is off the table, too, since the Fed will want to see more data and will wait for December.
Additionally, because the 4th of September is the Friday before the long US Labor Day weekend, this could make for some very exciting trading, either if (a) as we expect, the data will seal the deal for September, or (b) we are wrong and the data disappoints, suggesting a delay to December or into 2016.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Bluford “Blu” Putnam has served as Managing Director and Chief Economist of CME Group since May 2011. With more than 35 years of experience in the financial services industry and concentrations in central banking, investment research, and portfolio management, Blu serves as CME Group’s spokesperson on global economic conditions.
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