Fed Not As Convinced About June As Markets

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Includes: RINF
by: Tim Duy

Market participants place less than 10 percent chance of a rate hike in June. In contrast, San Francisco Federal Reserve President John Williams continues hold out hope for a third. Via Reuters:

Two to three rate increases this year "definitely still makes sense," he said...

Williams, a centrist whose views are generally in line with those of Fed Chair Janet Yellen, said he has not yet conferred with his staff economists over whether the next rate increase would be best made in June, July or September...

...With most gauges of the labor market suggesting the United States is at or nearly at full employment, he said, and inflation set to rise to the Fed's 2 percent target in two years, "things are definitely looking good."

Delaying rate hikes for months, he said, "would force our hands a little bit to move much more quickly in 2017."

Williams follows on the heels of Kansas City Federal Reserve President Esther George and Boston Federal Reserve President Eric Rosengren. The former clearly wants a rate hike, the latter, like Williams, not convinced that June is off the table. Williams adds the possibility that market participants are in for a rude awakening come June:

"Hopefully, if the markets understand our strategy, understand the data the way we do, then they won't be too surprised by what we do," Williams said. "I definitely don't think we need to go into a meeting with the markets convinced that we are going to raise rates in order for us to raise rates."

I think the Fed increasingly believes the data is lining up in their favor. Friday's retail sales report likely went a long-way toward dispelling any lingering concerns they might have over the strength of the consumer. The tenor of that data has picked up markedly in the last few months:

RETAILa0516

Note that one should not read much into the problems of department store retailers like Macy's (NYSE:M). They are simply playing a losing game:

RETAIL0516

This, among other data, is pulling upward the Atlanta Fed's estimates of Q2 growth:

GDPNow0516

Here though I would urge caution - this estimate can come down as quickly as it went up. If the Fed were confident that growth was in fact 2.8% in Q2, then they would move in June. But the reality is they are not likely to have sufficient data to justify that degree of confidence. That leaves me concluding that June is still not likely to happen.

But given the direction of the data, the improvement in financial markets, and the predisposition of a significant number of policymakers to raise slow, I would not be surprised if market participants revise their expectations that June is a sure thing. Remember that if we assume July and October are off the table (lack of press conferences and/or proximity to election), then retaining the option to hike three times requires a hard look at June. I think that will lead to a much more extensive discussion of a rate hike at the June meeting than many market participants appear to expect.

In the meantime, despite an improving Q2 outlook and healthier financial markets, the yield curve flattened further:

Spread0516

The 10-2 spread was just 95bp at the end of last week. Now, before anyone panics and screams that this implies slow growth, it is worth remembering that the spread was consistently below 100bp in the last half of the 1990s. And that was not exactly a slow growth period.

So why is the curve flattening? My story is this: The yield curve flattens whenever the Fed is in a tightening cycle. And the Fed most assuredly remains in a tightening cycle. They have not backed off their fundamental story that rates are headed higher. They see normalized interest rates on the short end as well above the current yield on the long-end. This seems entirely inconsistent with signals from the bond market and the global zero interest rate environment. In my opinion, the Fed continues to send signals that they intend to err on the side of excessively tight monetary policy.

That is the message of the dot plot. There is absolutely no reason the Fed needs to take a stand on the level of short-term interest rates three years hence. They don't know any better than anyone else. So why pretend otherwise? Why not do as Williams suggests and trust the markets to reach the right conclusion? In my opinion, the Fed's insistence on signaling an interest rate well above anything consistent with long-run rates isn't just bad policy. It is just plain stupid policy.

To expect the curve to steepen at this juncture, I think at a minimum you need the Fed to more aggressively commit to approaching the inflation target from above. You need to overshoot. That I think would be essentially an easing at this point. Chicago Federal Reserve President Charles Evans is already there. I think that Federal Reserve Chair Janet Yellen is getting there, but can't say it.

And even then, I don't know that approaching the target from above is enough. The dominance of the dollar in international finance means the Fed has a preeminent role in fostering global financial stability. A 2 percent US inflation target may not be consistent with global financial stability. And if it's not consistent with global financial stability, then it's not with US financial stability and thus not with solid US economic performance. Which means if the Fed is the world's central bank, they need to adopt an inflation target consistent with maintaining global growth. That might be higher than 2 percent. And they aren't going down that road without a long and nasty fight.

Bottom Line: I don't think the data lines up to support a June rate hike. But I don't think the case will be as clear-cut as signaled by the low odds financial market participants place on a hike.