In December 2015 the Fed raised their overnight rate for the first time in 8 years, and signaled that 4 more rate hikes were on the table in 2016. Shortly after market sentiment deteriorated, leading to skepticism about the central bank’s projected rate path. With data signaling that Fed should move more aggressively than the market is currently anticipates, the Fed is at a crossroads.
The Fed prides itself on having a “data-driven” dual mandate. They supposedly look at US economic releases to drive their decisions, specifically looking at the labour market environment and price level in the economy. These are highlighted by a number of indicators the FED tracks in their meetings: GDP, the U-3 unemployment rate, and Personal Consumption Expenditure (PCE).
In the most BLS release, the US unemployment rate has dropped to 4.9% , which is approaching the natural rate of unemployment. This is considered a normal level in an economy as workers transition between jobs. The last time the US had a 4.9% percent unemployment rate was 2007, at this point the Fed funds rate was 4%. So given their dual mandate, shouldn’t the Fed be tightening more aggressively now? How can the Fed claim to be data driven if their key unemployment indicator is within a percentage point of the lowest unemployment rate since 1970.
Employment Mandate Criticism
Looking back, the FED on numerous occasions has lowered their U-3 target for FED tightening, as the unemployment rate began to fall faster than anyone expected in the years following the financial crisis.
I still recall in 2013 when 6.5% was the magic number at which point the FED would consider tightening, although Bernanke later played it down as 6.5% or lower. The 6.5% target was reached in April of 2014 – a few months after Bernanke’s statement, although it took until December 2015, almost 2 years later before the first hike was completed by chairman Yellen. The Fed showed the market that it wasn’t very good at keeping policy promises.
Another big criticism is using the U-3 unemployment rate which doesn’t capture: discouraged workers, marginally attached worker, and workers who are part-time for purely economic reasons. All of these categories are included in a more broader unemployment rate, the U-6. Many would point to the significant decline in the U-6 rate since the financial crisis, but it’s important to note the magnitude has not been as drastic. Below, I created a custom indicator using the spread between the U-6 and U-3 unemployment multiplied by the labour force at the time. This illustrates a discrepancy of roughly 2-2.5 million workers who are underemployed.
While in a country of 300+ million people this may seem very small, at less than a percent. This amount becomes more significant when compared to the total labour force (150 mil) or to voter turnout (averaged 125mil in last 3 US elections), taking into consideration families and communities that are affected this number can exert a large pressure on society. Another indicator that is sometimes overlooked, such as the labour force participation rate, which has dropped to a multi-decade low of 62.7, illustrating a structural change in the US labour market post financial crisis that policy makers should be wary of. This article does a great job illustrating the US labour market progress since the crisis.
Price stability for the FED means targeting inflation at a 2% rate. The US inflation rate has remained relatively low post crisis even with trillions of dollars of assets purchased by the Fed through their QE programs. Inflation was expected to increase as labour market tightness pressures employers to raise wages, but this wasn’t really seen in 2014. In 2015, the lower oil collapse cast a veil of confusion, as lower oil prices lead to deflationary pressures that rippled through economies across financial markets. This kept the Fed in a “patient” mode as it awaited evidence of mounting inflationary pressures in the economy.
Price Stability Mandate Criticism
Curiously, PCE rose aggressively(arrow) in the last few releases, even as oil plunged from $45 to $25. This is surprising as in 2014 we saw a strong correlation between PCE and the decline in crude prices, leading me to believe that inflation would have been even stronger if oil maintained it’s price. This means the inflation rate is approaching Yellen’s target ahead of schedule. So shouldn’t this push Yellen to act more aggressively? There are finally healthy inflation pressures building, shouldn’t the Fed begin to act swiftly?
Regardless of where you expect oil prices to go, there is not much room to decline below $26 and as I detailed in my oil post the price will rebound this year, at least to the high 30s and could even go as high as $50, if oil prices move too quickly (potentially due to geopolitical instability), it could lead to a potential inflationary shock, made worse by a lower Fed Funds rate.
Some further evidence of rising inflationary pressures can be seen in the wage inflation, pictured below that begun picking up steam in early 2015. The inflationary effects of this rise were likely understated due to oil collapse impact.
Given these accelerating inflation pressures, and assuming the Fed is really data driven, it should be accelerating it’s rate hike cycle in 2016, from 4 to maybe 5 or 6.
Criticism of the Fed
Even in the face of mounting pressures from the labour market and price level, the market has discounted any significant rate hikes in the near future and rightfully so – the Fed has a bad track record of delivering on promises. To illustrate this dissonance, I have two figures. The first figure is the Fed’s dot plot from their December meeting, while the other is the FED Funds rate projections I created using FED Fund futures.
If you look closely at the dot plot, you see that the majority of the Fed members believe that 4 rate hikes would be appropriate by the end of 2016. This seems very optimistic considering just half a year ago the Fed committee was projecting 2-3 rate hikes in June, but were only able to deliver 1. The Fed’s consistent inability to deliver on their promises has led to the market discounting the Fed’s projections almost entirely.
In the figure above, we can see that even before the 2016 turmoil began, the market was pricing in 2 rate hikes by the Fed in 2016, only half. By the first week of February, the Fed fund futures had the first fed tightening occurring in late 2017. As more concerns mounted about growth in the global economy, the tightening was pushed even further to mid 2018. I never believed the Fed would raise rates 4 times in 2016, but there will a rate hike in 2016. My view has been since April 2014 that rates would rise 1-3 times in 2016, with 2 rate hikes the most likely outcome, downgraded to 1 if we have further significant market volatility in 2016, and upgraded to 3 if inflation is persistent. The market and the Fed have a big disagreement on the path of hikes, and it will be the Fed doing the adjusting in the next policy meeting on March 16th.
Thus far, I have urged the Fed to act more aggressively in their tightening cycle, this is assuming they followed a dual mandate, as they claim. I don’t believe they do, and they shouldn’t – the economy has many complicated relationships and so a very static approach could prove devastating. There are serious headwinds that could pose a bigger threat than a bit of inflation such as:
- USD Strength
- Lower earnings for US domiciled companies
- Emerging market competitive devaluation
- Emerging market US-denominated debt crisis
- Commodity/USD-led currency collapse and instability
- Global Growth
- Tightening too quickly could cool US and global growth
- China may have a hard landing, causing Fed to roll back some tightening
- Yield curve flattening hurting beleaguered banks
We must consider one last key point regarding the members of the rate setting committee: they are academics, they have a personal reputation and they are human. In the face of global economic uncertainty, the Fed will yield to the markets and will err on the side of caution when faced with the possibility of a policy mistake.