The Fed's Decisions This Week And Beyond

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About: SPDR Dow Jones Industrial Average ETF (DIA), Includes: IWM, QQQ, SPY, SPYB, SPYD, SPYG, SPYV
by: J.G. Collins
Summary

The Fed will almost certainly raise rates this week, but the reasons are nebulous and subjective.

The purported "data dependent" Fed is really just "date dependent", a victim of its own prognostications and Wall Street expectations.

After this week the only driver of full employment and sustained 2% inflation in the broad economy will be PEOTUS Trump's fiscal policy, not the Fed.

But new fiscal policy will take months to realize.

"Normalizing rates" further now is a mistake, even though a rate hike is "baked into the cake" of the market.

The market has priced in a strong expectation that the Federal Reserve will raise interest rates when it meets Tuesday and Wednesday. It will announce its decision on Wednesday. The larger question, though, is whether the Fed will raise rates beyond this widely-anticipated December hike.

So, let's look at some numbers:

First, core inflation, the fed's preferred data point for the statistic, printed at 2.1% in October, the last month for which data is available. That is down 1/10th of a percent from the September number of 2.2%. Indeed, core inflation has averaged 2.2% - above the Fed's targeted 2% rate -- since January.

But that "above target" number should not necessarily be considered to be a "green light" for a December Fed rate hike. We have experienced a 2% core inflation rate several times over several consecutive months, most notably from August 2011, to July 2012; a full 12 months of core inflation above 2%.

Consider, too, that, as the Financial Times pointed out a few months ago, most of that 2% core inflation rate has come from the least productive sectors of the US economy: higher education, healthcare and prescription drugs. We are not seeing the higher inflation in commodities or most of the broader economy.

Second, while November unemployment was just 4.6% (down from 4.9%), most of that drop came from fewer workers in the workforce. Moreover, as I have discussed in our monthly employment data (see the most recent here), most of the private sector employment growth has been in sectors that pay poorly or that are in sectors like healthcare, education, and social Services that are heavily subsidized by government.

Average wages in the November jobs report also printed down from the prior month. Since December of 2007, the starting point of the Great Recession, average weekly wages have increased from $728.59 in December, 2006, to $890.62 in November.

But in real terms, wages have been stagnant. Average weekly wages of $728.59 in December, 2006, works out to just $877.76 when adjusted for core inflation through October 2016, when average weekly wages were $891.65. That works out to a negligible average weekly wage increase of just $13.89 in nearly nine years.

The broader statutory mandate of the Fed is, of course, to maintain full employment and stable prices. While the marketplace is factoring in an all-but-assured rate increase Wednesday, it seems almost certain to me that it will be some time before the Fed increases rates considerably in 2017.

To be frank, I don't see that objective circumstances have changed so significantly as to require a December rate hike. We've seen this movie before where the demands of an impatient marketplace, the pundits, Fed member banks, and the public commentaries of Fed officials themselves have caused rates to increase.

Remember just a year ago when the Fed cornered itself and said it would raise rates for months and then did? But when they did, employment disappointed (151,000 jobs in January 2016, when the consensus was for 190,000) and Real GDP growth slowed from December 2015Q4 Real GDP of 1.9% to 1.6% in 2016Q1 to 1.3% in 2016Q2.

In my opinion, a rate rate hike this week seriously risks the Fed's claims of being "data dependent" in its decisions; instead, it will be viewed as simply "date" dependent: "We said we would raise rates soon; today is 'soon'."

The Chicago Fed National Activity Index CFNAI data shows it is highly unlikely that we are entering into an inflationary environment. Even if we were (for example, because of President-elect Trump's fiscal policies), the FED has a variety of new tools to snap back inflationary pressures that it did not have even 10 years ago.

My view is that the Fed will adopt 25 bps increase in rates on Wednesday, but probably shouldn't; not until we see sustained, stable, employment growth with better-paying jobs and a firm level of inflation of 2% in the broader economy. After Wednesday, I don't expect to see another increase until at least the second half of 2017.

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