A Mosaic Approach to Raising the Fed Funds RateLearn more about this firm
Mosaics are beautiful, but they’re hard to put together.
One of the most momentous developments in monetary policy this year has been the Fed’s departure from using a soft target of 6.5% unemployment as the trigger for an increase in the fed funds rate. Instead, as the Fed explained in its March FOMC meeting announcement, it’s going to assess the health of the economy using a wide range of information including labor market data, inflation pressures and expectations and other financial developments.
Yes, rather than focusing on just one metric such as the unemployment rate, the Fed will be looking holistically at the economy, reviewing a mosaic of data to determine whether the economy needs further accommodation. While this seems sensible given that one metric may not give an accurate indication of the state of the economy, it adds a level of uncertainty for investors. The challenge is trying to understand when—and how quickly—the Fed will begin raising short-term interest rates, and what that means for stocks.
Tapering, Then Tightening
Despite the Fed’s insistence that tapering is not a pre-set course, it seems to be on that exact path. The market recognizes that it will take a significant change to alter this timeline. As a result, we’re seeing investors trying to gauge the timing of the first rate hike and position themselves accordingly.
While the economy appears to be growing faster in the second quarter than the first quarter, there are a few factors that may hasten or postpone the Fed’s decision to raise its target rate. The biggest factor that can accelerate the start of tightening is inflation. And we’ve seen a significant increase in inflation recently. CPI rose 0.4% in May—doubling expectations—on the heels of a 0.3% increase in April. Inflation is now running at 2.1% year over year, which is above the Fed’s “soft” target for inflation.
Why is the Fed resisting raising short-term rates for now? First, the Fed views the personal consumption expenditures deflator, not the consumer price index, as its primary measure of inflation. And the PCE deflator is running much lower than the CPI. Second, the FOMC needs to see inflation remain higher for a sustained period of time, as the recent move could be a temporary spike. It must be significant enough to change inflation expectations.
“… we haven’t yet seen the significant wage inflation that [Janet Yellen] believes is necessary to produce a sustained rise in inflation.”
But most importantly, Fed Chair Janet Yellen doesn’t believe inflation is an issue. Why? Because we haven’t yet seen the significant wage inflation that she believes is necessary to produce a sustained rise in inflation. However, if inflation continues to rise, and remains elevated, then the Fed will have less and less flexibility. At some point, the Fed will be forced to take action.
Alternatively, housing weakness could result in the Fed keeping monetary policy looser for longer. Last week, May housing starts and the latest weekly mortgage applications came in lower than expected. And while the housing market index indicated solid gains for June, traffic was anemic—a sign that there isn’t widespread participation in the housing market. In fact, housing has really been in the doldrums since last summer, when mortgage rates began to rise in the wake of Ben Bernanke’s “taper talk.” However, we have seen some improvement since the harsh winter ended.
Last month, Yellen explained that even though the economy is showing some signs of improvement, there are concerns over the housing market: “One cautionary note, though, is that readings on housing activity—a sector that has been recovering since 2011—have remained disappointing so far this year and will bear watching.”
Further, she reiterated her concerns about housing in the FOMC press conference last week. Those concerns are justified because home prices are closely tied to the health of the economy. Indeed, many consumers’ net worth impacts their confidence and their level of spending, a phenomenon known as the “wealth effect.”
However, we haven’t seen enough housing weakness to warrant the Fed becoming more accommodative any time soon. As we look ahead to this week, investors should pay close attention to indicators of housing-market health and signs of a further increase in inflation. We expect greater uncertainty and less direction in the stock market now that the Fed is looking at a mosaic of economic data rather than just unemployment.
While the mosaic approach may be a more appropriate way to determine when to reduce accommodation, it’s likely to cause confusion. It also may lead to some missteps by investors as they attempt to divine the Fed’s next move.
Kristina Hooper, CFP, CAIA, CIMA, ChFC, is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
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