The Federal Reserve decided to hold interest rates at their 0.25%-0.50% range for the fifth straight meeting after hiking in December 2015 for the first time in nearly a decade. This was a widely expected move given the overseas developments in the U.K. and EU since their last policy meeting. However, Fed Futures have rebounded from post-referendum lows and are now sporting a coin flip's 50% chance of hiking by year's end. With economic data performing well lately, GDP expectations being pushed higher, and the surprisingly muted impact of Brexit now dissipated, the prospects for a rate hike in September are a strong possibility, and with good reason.
U.S. economic data has performed well this year and has surprised to the upside lately (Citi's Surprise Index, comparing expectations of economic data to their actual performance, has ticked higher everyday for the past six weeks). Looking broadly at first, housing continues to prove a strong sector for the domestic economy, with strong demand still outpacing supply, mortgage rates near historic lows, and existing home sales rising at a 1.1% clip from last month, the strongest rate since 2007, which is an important data point as existing home sales account for nearly 90% of all housing purchases in the nation, according to the WSJ. Housing starts rose 4.8% month-over-month, with the latest report showing that homes under construction are at the highest level since 2008, also according to the WSJ. Demand is still outpacing supply and pushing prices higher. Inventory levels are a concern, but as supply eventually catches up with demand, Fed normalization pushing mortgage rates higher could be offset by lower prices, sustaining housing market growth and stability.
Housing has been strengthened by a strong job market, perhaps the brightest spot in the economy over the past 12-18 months. After topping out at 10% coming off the Recession, unemployment currently sits at 4.9%. As part of the Fed's dual mandate, many economists, analysts, and even Fed officials would argue that the U.S. labor market is near or at full employment. However, hiring has slowed as of late, with the second quarter averaging 147,000 hires following the first quarter's 196,000 and 2015's average of 229,000, the second best this century trailing only 2014. Participation has been a poor spot for a while, and labor criticisms arise from looking at a) the number of underemployed workers, which may suggest still more slack; and b) rather frustrating wage growth.
However, wages have been rising at pretty healthy clips, with average hourly earnings up 2.6% in June, a level that has not been breached since 2009. And sure, the argument that unemployment is not really at 4.9% because so many are not in the jobs they want to be or are not working but want to be carries validity, warrants further study, and perhaps justifies some model updates. But jobless claims just hit a three month low and have been below 300,000 for 72 straight weeks, the longest streak since 1973 according to CNBC and Reuters, further bolstering a still strengthening labor market.
With these rising wages coming from a tightening labor market, the other side of the dual mandate, inflation, should fundamentally push higher. With Americans exhibiting strong earning and decent spending trends, price growth has been a frustratingly slow trend for the FOMC and one that has equally confused economists. Core PCE year-over-year, the Fed's preferred measure, has been on the rise since 2H15 and currently sits at 1.64%.
Wages should be a positive sign higher, but consumer spending has started trending downward, with some even pointing at the Fed's lower-for-longer rates as actually hurting spending by eating at the value of savings and investment, starting to reverse the strong trend we saw in 2015 and decreasing spending. Nonetheless, inflation has been on a strong trend higher and is moving towards the Fed's 2% target, in which the directionality is what the Fed is looking for and has mentioned would give them the confidence to move forward with normalization. And for what it's worth, CPI has grown stronger than PCE lately and is currently at 2.3%.
Taking all of this into consideration, the economy is certainly not in a stellar state. Productivity has been a long-standing problem that continues to drag down inflation, hiring and capacity utilization, among other indicators. Manufacturing has ticked up to 52.9 this month, but has still trended lower for years, hurt by the stronger dollar and broadly decreased demand. Services have also lagged as of late, and overall GDP growth in the post-crisis era has continued to grind at a new normal of just over 2%. We also can't dismiss the uncertainty the U.S. election brings to the markets as well.
And that's just domestically, with issues overseas also in need of consideration. The U.K.'s June 23rd referendum vote to leave the European Union shocked the world and threw economists, politicians, and policymakers alike into uncertainty and confusion. The feel in the markets the following two trading days was one of turmoil, as many expected the impacts to be felt globally, send equities lower, bonds higher, and prospects for future growth plunging. However, the reaction to the global economy has been largely the opposite, with markets exceeding levels economists thought they would not even see with a 'Remain' vote. Aside from this, at their next policy meetings: the BOE is expected to ease, the ECB may expand their buying program as bond supply thins and growth stagnates, and the BOJ is expected to pair pending fiscal stimulus with possible monetary help. The policy divergence has left the Fed all alone in the tightening camp and put Washington in a tough spot. Oh, and let's not forget that negative interest rates are currently fostered by 20% of global GDP and are dragging down yields on $13B of debt.
Clearly central bankers around the world are in very difficult and uncharted territory, not the least of which is our very own "central bank to the world" led by Chairwoman Janet Yellen. Nonetheless, given how the economic data and markets have performed as of late, the case for September seems strong. The economic laggards above are longer-term problems and were present when the Fed hiked last December and when they made the four-rate-hike call for 2016. The Fed has been discussing the normalization of policy for some time now, but always seems to find a reason for it not to be the case, whether it be too low inflation, poor productivity, anemic wage growth, or a clouded global outlook.
Some economists and analysts have been frustrated as they seem to be waiting for the perfect moment to hike. But in actuality, there will always be lagging indicators, underperforming data, pressure from overseas or misaligned stars; they have been present in past tightening cycles and if the Fed doesn't normalize soon, they run the risk of variability in data or other developments going negative, giving them yet another reason to delay further.
Given how markets and Fed Funds Futures have bounced back from Brexit seamlessly, economic data have performed very strongly and surprised to the upside, and with the tumult from Brexit on hold at least until negotiations start in 2017, a rate move in September is warranted and could signal confidence in the domestic economy amid a global growth grind, encourage growth in other parts of the world, start boosting the value of savers' assets and establish a more consistent and sustainable path towards normalization and reduce the extreme caution that has actually hurt the Fed and contributed to the tough situation they are currently in. At the end of the day, all of this media coverage and debate is about a quarter of a percentage point, which would not have all that major of an impact on investment or spending. The Fed feels the pressure to normalize monetary policy, and September presents a strong time to do so.
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