Tough to read the signals when there’s so much noise.
Last night I awoke to a distant clap of thunder at 2:30 AM. Shortly thereafter a tremendous wind picked up and with it came a violent thunderstorm and the requisite downpour that made so much noise that I couldn’t immediately return to sleep. As I lay there two thoughts were on my mind…how much damage would this do to the house?…and when will my daughter run from the thunder and show up beside the bed?
Before I could assign probabilities to either scenario my thoughts were interrupted by a distant wailing sound. The noise came to me in peaks and valleys as the storm’s intensity ebbed and flowed. This noise concerned me because it could be one of only two things…both very familiar to people in my part of the world. It’s either a train pushing its way through the storm or it’s a tornado siren…one requires no action and the other requires immediate attention.
Ultimately it turned out to be the wail of a freight train’s horn reaching me through the wind and rain, ultimately it took my daughter about 5 minutes to come looking for momma…and ultimately I lay there a while longer in the darkness comparing my recent train/tornado conundrum to the current state of economic affairs.
Those who are attempting to determine which way this economy and market are heading are dealing with some of the same issues that I dealt with last night. There are signals available that may help decipher the appropriate course of action but they are at times inconclusive and seemingly pointing toward different paths…each with a drastically different outcome.
In a recent webinar we discussed the Fed’s outlook on interest rates. The FOMC committee is increasingly split into two camps. One says that achieving the Feds dual mandate of full employment and price stability must come first. The other says that the appropriate action is to reverse course on QE2 and normalize rates before the dual mandate is achieved in order to reduce the risk of unintended consequences.
Who will win?
Currently there seems to be more support for those who desire to achieve the dual mandate first and keep rates “exceptionally low for an extended period”. Based on what we’ve heard from the Fed the QE2 program is likely to continue unabated through its scheduled conclusion in June. From that point it’s reasonable to consider that the Fed will wait and watch the data before taking their next step. In other words it seems unlikely that we’ll get to the end of QE2 in June and see the Fed immediately begin to tighten.
So how long will they wait? As always…they will be data dependent. I would expect that any move to tighten would be preceded by analyzing several periods of data to ensure that we have a sustainable trend of growth. Any tightening (whether a reversal of QE2 or an outright increase in the overnight rate) would also be preceded by a great deal of communication from the Fed. There won’t be any surprise moves from the Fed on this issue. They’ve gone to great lengths to let us know that communication is a high priority item for them. They understand that the complexity of their current monetary policy necessitates clear communication of any plan that begins to reverse our current course.
So after the June 2011 conclusion of QE2 we should expect some period of time where the Fed monitors the data, comes up with a plan for raising rates, and communicates that plan to all interested parties. One could easily see this process taking months or quarters. As a reference point the Bloomberg Survey data doesn’t show an expectation for higher Fed Funds levels until 1Q 2012.
What are they waiting for?
Business cycles evolve over long time periods so it’s easy to lose one’s feel for how the course of monetary policy unfolds. Given our current state of affairs I thought it might be interesting to look back at the last tightening cycle that began in June 2004. I won’t suggest that this cycle will be like any particular cycle from the past…what I’m more interested in is seeing just how much positive data the Fed had to have piled up in front of them before they decided to begin a tightening.
It is interesting to note that after the last recession we had 12 months between the first mention of “firming of spending and markedly improved financial conditions” and the first rate hike by the Fed.
In the 6/25/03 FOMC statement the Fed saw:
- Robust growth in productivity
- Firming in spending
- Markedly improved financial conditions
- Labor and product markets stabilizing
Even against that macro-economic backdrop the Fed thought that an accommodative policy was the right one and they left rates low.
Skipping forward 6 months to December of 2003 we get an FOMC statement that sees:
- Robust growth in productivity
- Output expanding briskly
- Labor market improving modestly
- Low inflation
- Considerable resource slack
Again the Fed left rates low…they have a lot of things moving in the right direction but it will still be six months before the Fed tightens.
Now let’s look at our most recent FOMC statement from March 2011:
- Recovery on firmer footing
- Conditions in labor market improving gradually
- Spending continues to expand
- Housing and non-res. Investment depressed
- Long term inflation stable
- Short term inflation subdued
While our last FOMC statement looks somewhat similar to the Dec 2003 statement there are a host of very important distinctions between the two time periods.
Capacity utilization, consumer spending, and inflation expectations are fairly similar when compared between the two periods. In 2004 however the Fed was in a pretty good spot with regard to their dual mandate…unemployment was 5.6% and inflation was running at 2.2%. Both numbers were manageable if not optimal. Another major difference is the fact that the housing market wasn’t in shambles in 2004.
These are just a few of the items we could look at when studying this issue but I think it helps to note that in June of 2004 the Fed was starting from a much less perilous position than they are today…by comparison it was easy to raise rates in the summer of 2004.
Today they are failing on both counts of their dual mandate…the unemployment rate is at 8.9%, and inflation is below their 2% comfort level as measured by Personal Core Expenditures (PCE) at 0.9%. Additionally they are still actively engaged in easing as they are 3 months from completing their most recent monetary easing plan (QE2).
Based on history and our current position it’s easy for me to see how it could be 1Q of 2012 at the earliest before they begin tightening. As always they will be data dependent and they will continue to telegraph their plans before they take action.
I wish I could get to the end of this Market Update with a smoking gun in my hand and say “The Fed will raise rates on (insert date here)” but the issue is far too complicated. The best we can do is listen to the Fed as they debate the issue and keep in mind that their dual mandate of maximum employment and inflation will be their guide.
If you have any questions or if there is anything I can be doing for you just let me know.
Steve Scaramastro, SVP
800-311-0707
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