Barring a “shockingly negative” event occurring before the Federal Reserve’s meeting starting December 15, last week’s better-than-anticipated US payroll numbers for November are almost certain to prompt the central bank to raise rates by 25 basis points. All things considered, however, the move might not be so great for business
The 211,000 payroll increase was a tad higher than anticipated and October’s number was revised upward, while the US jobless rate held steady at 5%. “The Fed is convinced it needs to do a pre-emptive interest-rate hike, and now it’s going to do this unless something shockingly negative happens,” says Robert Tipp, chief investment strategist and head of global bonds and foreign exchange at Prudential Financial. He adds that a stock market crash between now and the Fed meeting was the most likely candidate.
Another major player in the bond market concurs. “This [job] strength, when taken alongside firming wage rates, clearly indicate[s] the economy’s readiness for the start of interest-rate normalisation from the Fed, and we think a December move is all but assured,” says Rick Rieder, chief investment officer of fundamental fixed-income at BlackRock, in a note to clients.
Nevertheless, should the Fed raise the Fed Funds rate it will be testing unknown waters. Tipp says that the central bank has historically moved when inflation is at or above target, and wage pressure and gross domestic product (GDP) growth are higher – neither of which is currently the case. “This time, they’re really moving on the suspicion that monetary conditions are too stimulative, and the economy is getting near full employment and they don’t want it to overheat,” he adds.
Tipp acknowledges that US unemployment, now down to 5%, is relatively low. However, the employment to population ratio fell dramatically in the wake of the recession starting in 2007 and remains very depressed. While retiring Baby Boomers may be a factor, the slump appears at least as much cyclical than due to demographic changes.
In terms of inflation, the US core inflation rate, which excludes food and energy, has increased to 1.9%, and there are several areas besides food and energy where inflation is running around 2%. That’s positive, but headline consumer price index (CPI), which includes everything, is closer to zero. Tipp says that the monetary policy “settings” the Fed has run for the last 20 years have been disinflationary. Now that inflation is somewhere between 0% and 2%, continuing such policies may strengthen the dollar further, keep inflation below target and risk slowing the economy.
Fed chairman Janet Yellen and other board members have emphasised that rate increases will be few and far between, and on the surface it is difficult to see how raising rates to 1% or 2% could cause much damage. Tipp notes, however, that it is a different world today. Leverage in the economy is much higher, so rate hikes may have outsized impact. Furthermore, many developed economies are moving in the opposite direction – the European Central Bank (ECB), for example, cut the deposit rate yet again last week, by 10 basis points to -0.3%, and it is pursuing quantitative easing that the Fed stopped last year.
This divergence in the central banks’ policy could fuel a further surge in the dollar, spelling the end of US expansion, market turmoil, or both, if the past is any indication, Tipp said.
First of three?
America’s employment gains have been relatively strong for several years, core inflation has bumped up a bit in 2015, and wage growth has accelerated to 2.2 % now from 1.7% at the start of the year – all factors pointing to an improving economy. However, that assessment ignores today’s complete lack of headline inflation, which was closer to 3% the last time that the Fed started raising rates back in 2004. In addition, today’s wage growth remains anaemic compared to the 10-year average of 3.45% before the recession, which sometimes reached up to 4%.
“And it’s not like the rest of the world is doing great, and they’re going to help pull us up by our bootstraps … we’re kind of the last man standing, and it’s a question whether the Fed will threaten that,” Tipp says.
BlackRock’s note describes a December move as all but assured, but it also acknowledges signs of weakness in the global economy as well as domestic economies. “Still, we must recognise that there are structural challenges embedded in the economy today, as manufacturing sectors continue to remain sluggish – but that would argue for more targeted fiscal policy action, which is unlikely to be forthcoming anytime soon,” notes Rieder.
Somewhat counter-intuitively, the ECB’s latest decision to lower European rates further probably increases the likelihood of the Fed moving in the opposite direction. Tipp says that central banks acting independently to support their respective economies essentially give the Fed the freedom to focus on what it determines to be the correct policy for the US.
Rieder predicts “perhaps two rates hikes in 2016 after the initial December move,” half the number forecast by the Fed’s Federal Open Market Committee (FOMC). Given the domestic and global challenges the Fed faces, he adds: “Normalisation will be a very gradual and controlled process as a result, and both the economy and markets should be largely prepared for it.”
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