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The April Federal Open Market Committee meeting minutes released last week caused a bit of a stir in capital markets: Stocks fell, the yield on the 10-year Treasury rose and expectations of a rate hike, as indicated by fed funds futures, rose materially.
Wading through the Fed’s minutes, one key section could be a helpful guide for what might happen in the coming months: “Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee’s 2% objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June.”
Interestingly, Boston Fed President and voting FOMC member Eric Rosengren just told the Financial Times that “most of the conditions that were laid out in the minutes, as of right now, seem to be ... on the verge of broadly being met....”
So let’s examine each one of these three conditions—economic growth, jobs and inflation—to determine whether the FOMC is likely to increase the fed funds rate in June.
Issue 1: Is the Economy Growing?
The Fed wants to know whether economic growth has been picking up in the second quarter, and the regional Fed banks have slightly different opinions about that question. The Atlanta Fed GDPNow model forecast for annualized real GDP growth for the second quarter was 2.5% on May 17, down from 2.8% on May 13. The New York Fed’s Staff Nowcast estimate of GDP growth for the second quarter is lower, but it reached 1.7% last week—half a percentage point higher than the week before—boosted by positive manufacturing and housing data.
Despite differences between the Atlanta and New York Feds’ estimates, both seem to indicate that growth is picking up. But will it continue? For answers, take a look at the Index of Leading Economic Indicators, which rose 0.6%—an acceleration over previous months. Interestingly, the manufacturing sector is now viewed as a positive for the index, contributing to an overall reading that suggests that the pickup in growth will continue.
Issue 2: How Healthy Is the Job Market?
As the Fed considers whether or not to raise rates in June, it’s also looking at whether US labor-market conditions will continue to strengthen. The jobs recovery has certainly slowed recently, with the April jobs report showing non-farm payroll growth well south of 200,000.
And despite the fact that wage growth has improved slightly and the unemployment rate is holding steady near its 5% target, the 19-point Labor Market Conditions Index has declined for the past several months—although it fell less this past month. This seems to suggest that labor-market conditions may not have strengthened sufficiently for the Fed to raise rates, although it’s a close call; we’ll need to see the May jobs report to get more clarity on this condition.
Issue 3: Is Inflation Moving Up?
The third and final question is whether inflation is making progress toward the FOMC’s 2% objective. Here’s what the most recent data show:
- The April Consumer Price Index rose 0.4% for a nice boost to headline inflation, while core inflation rose a solid 0.2%.
- The year-over-year rate for core inflation is less impressive, at 2.1%, but it’s still above the Fed’s target rate of 2%.
- The Federal Reserve Bank of Cleveland’s estimate of 10-year expected inflation is 1.75%; this is notable because the Fed looks not only at actual price increases but at expectations of price increases.
- Consumer inflation expectations for the 1-year period have come down based on the most recent University of Michigan Consumer Sentiment reading, but business inflation looks a bit better. The Atlanta Fed Business Inflation Expectations Index shows a two-tenths rise to 1.9%—the strongest reading since January.
How Will the Fed Respond?
So what’s the Fed to do? The conundrum is that at least some of the recent pickup in economic growth is arguably attributable to the weaker dollar, given the solid improvement in the manufacturing sector. In turn, the weaker dollar is likely attributable to expectations of a very low fed funds rate path this year. So if the Fed raises rates, this could cause a slowdown in economic growth, necessitating another long pause—just like the one we experienced after the December rate hike.
Given the current state of the three areas the Fed is focusing on, the question of whether or not the Fed will tighten in June seems like a much closer call than most market participants believe. At Allianz Global Investors, a recent internal survey of our chief investment officers indicates a roughly 50/50 split on whether the Fed will raise rates in June. All told, it seems that possibility of a June rate hike is still very much on the table—and it could become even more likely if data released between now and the next FOMC meeting prove more favorable. But if June doesn’t happen, then July becomes a very distinct possibility.
However, don’t expect a summer rate hike to become the start of a series of rate hikes in rapid succession, given the Fed’s data-dependency. What we could wind up with is a “gas-brake-gas-brake” rate-hike cycle, where the Fed could raise rates only to see the economy slow, which would in turn cause the Fed to wait a while for the economy to recover before it acts again. As we’ve said before, we’re in an unpredictable environment, so investors would be wise to expect more surprises and more volatility.
About the Author
Kristina Hooper is the US Investment Strategist and Head of US Capital Markets Research & Strategy for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law, a master's degree from Cornell University and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.
Past performance of the markets is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities.
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