- The Fed has met its current policy targets.
- Inflation pressures are building.
- Interest rates are going to rise sooner and faster than the market expects.
The 30 July FOMC Statement contained the following message:
"Household spending appears to be rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow. Fiscal policy is restraining economic growth, although the extent of restraint is diminishing. Inflation has moved somewhat closer to the Committee's longer-run objective.... ..there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions."
The Fed has clearly stated it will not raise interest rates until the unemployment rate falls below 6.5%, subject to inflation being at or below its target 2%. We have been below the unemployment threshold for some time and latest figures indicate inflation breached the 2% target in June 2014. July data also suggests wage growth is accelerating. The Fed sees a sustainable recovery and its primary attention will now switch to inflation.
Inflation pressures are building
A number of trends in monetary aggregates that correlate to inflation gains, such as credit expansion or growth in M2 Velocity, are signaling inflation could accelerate.
Data Source: St Louis Federal Reserve. Change in M2 velocity measured as q/q change in 3-quarter moving average.
Key economic sectors are expanding or at trend, as noted by the Fed and shown in the graph below:
- Personal Consumption Expenditures are rising at trend rate;
- Investment spending is rising above trend rates;
- The reduction in Government spending appears to be coming to an end.
Data Source: St Louis Federal Reserve.
The graph shows that recovery to date (as previewed here) has been one of increased investment offsetting the fall in Government spending. This is a significant structural shift in the US economy, supporting higher productivity gains, but also below trend GDP growth and a rise in the long-term unemployment rate.
The economy is now at its average post-war unemployment rate of 6.1% and with the three major components of aggregate demand all rising, there is likely to be a demand pull on inflation.
Typically, at this point in the economic cycle, the US Fed would be raising interest rates, or at least signaling its intention to do so if the trend persists. This time, the Fed has repeatedly warned its current policy is "highly accommodative".
The Fed acts differently when facing an inflation threat
The graph below puts Fed policy into context when inflation goes above its "acceptable" level which today is defined as a 2% target rate. The Vertical Axis plots the log of the ratio of unemployment rate to the effective Fed funds rate. Given the unprecedented low interest rates under current monetary policy (captured in the circle and showing the current position), we are FAR OUTSIDE where typical policy has been since the 1950s.
The red dots indicate that statistically, the Fed has demonstrated a different policy approach when inflation has been above target, compared to when inflation has been below its target level.
Data Source: St Louis Federal Reserve.
Using this predictive model of Fed policy, the plot of actual vs. fitted interest rates shows the extent to which, typically, this model is conservative in estimating interest rate change.
The figure also shows that if the US Fed were following standard monetary policy, interest rates would currently be in the region of 3.0% and not at the 0 to 0.25% range.
ACTUAL vs PREDICTED EFFECTIVE FED FUNDS RATE
Data Source: Own Model Output and St Louis Fed Reserve data
The gear change is with us now
If the US Fed allows inflation to rise above target, it will undo the inflation expectations that the Fed and other central banks around the developed world worked so hard to anchor to their targets. The Fed will NOT let that ship adrift.
Furthermore, under current policy, the Fed may be concerned with investor complacency and interest rate insensitivity; given the historically long period over which interest rates have not shifted.
I strongly suspect the policy change is being discussed internally right now. The Fed will be signaling its inflation concerns at the next meeting (because inflation pressures are very unlikely to recede by then).
If markets do not respond with higher rates and a moderation of inflation pressures by themselves, the Fed will be raising rates by the end of the year.
Implications for investors
In a "normal" world the Fed would have been raising interest rates to 2-3% at this stage of the business cycle. In a world of lower inflation expectations and fragile financial system, the Fed is even more sensitive to inflation going above target than ever before. Current consensus suggests no rate rise until mid 2015 when rates will rise by around 0.5%.
I anticipate that, with the current state of expectations, market and macro trends the Fed will raise interest rates sooner and faster than the market anticipates. If I were to be pushed for a number, I would say 1.0% to 2% by mid-2015.
The key phrase in my mind is the FOMC's own words stating ".. the likelihood of inflation running persistently below 2 percent has diminished somewhat" and "the risks are evenly balanced."
The committee is changing gear, mentally preparing to shift the fight from deflation to inflation.
This assessment is based on all information at hand today and current market expectations. We must bear in mind that the only thing of the future we can be certain of, is that our view of it will change.