Why The Fed’s September Interest Rate Decision Is A Coin Flip

Will they or won’t they? With less than a week to go until the Federal Reserve’s hotly anticipated September policy meeting, where the committee will fall on the question of rate hikes remains unclear — even to members.

The 10 economists who make up the Federal Open Market Committee have three options to consider this Wednesday and Thursday. They could do nothing and again issue a post-meeting statement that says they will act once they have “seen some further improvement in the labor market” and have confidence inflation will move toward 2% “over the medium term.” They could rip off the band-aid with a 0.25% hike, raising the federal funds rate for the first time in close to a decade. Or they could take some middle-ground, not hiking but wording the statement in a way that makes everyone pretty sure they will soon and then use Chair Janet Yellen’s post-statement press conference to drive home the proper reading.

News reports suggest that as recently as the middle of last week committee members were unsure which option to choose. Last Wednesday, in anticipation of the meeting, the Fed began a blackout period, meaning the financial world will not hear from the policy makers until a decision is made.

Adding to the impression of inconclusiveness is the fact that Yellen has not spoken publicly since testifying before Congress two-months ago. In mid-July she reiterated her view that liftoff from zero would come this year. A few days later the Fed once again held tight, as anticipated, and the countdown to September began. (The Fed did not meet last month.)

Since then stock market turbulence in late August, seemingly driven by evidence of slowing economic growth in China, generated fresh debate about the wisdom, necessity and likelihood of an imminent hike.

Though Yellen has been mum, the Fed’s number two, Vice Chair Stanley Fischer, in a speech suggested that the committee had not given up on acting this year but that they were keeping tabs on the same international factors that had stuck fear in investors.

The remarks were delivered at the annual central banking conference in Jackson Hole, Wyoming, which took place near the height of market volatility. He told the economists gathered that given the unlikelihood of oil prices dropping much farther there is “good reason” to expect inflation will begin rising sooner rather than later. Since the Fed is inclined to act before inflation hits their 2% target the remarks point toward a hike. However, according to the New York Times Fischer declined to say when. “I will not, and indeed cannot, tell you what decision the Fed will reach Sept. 17,” he reportedly said.

If you’re thinking the wisdom of the crowd could determine when the FOMC will act before members do, the edge goes to not hiking this week. According to the Chicago Mercantile Exchange, just 23% of futures investors anticipate a September rate hike. Traders can use Fed-funds futures to wager on timing and pace of interest rate moves. The probability jumps above half in December, to 58%, but as recently as early August a similar bet was being made on this month. In a recent Wall Street Journal survey of private economists 46% said the first rate hike will come this month; 35% predicted a hike will come in December. The FOMC will meet again in October and December but most people expect action to come in a meeting followed by a press conference.

To try your hand at this guessing game consider the key data received since the Fed last met.

The Bureau of Labor Statistics released two reports on employment the most recent of them showed employers adding 173,000 jobs last month while the unemployment rate dropped to 5.1%. That is the lowest percentage of unemployed people in the labor force since April 2008 and below the 5.2% to 5.3% the Fed had forecast for year-end. Though the payroll count was light compared to the recent average it is expected to be revised higher in the next monthly report, as is often the case, particularly with the August count. Thanks to revisions recorded in the August report the June and July figures were 44,000 higher than previously reported.

At the time Tara Sinclair, chief economist at job search site Indeed, noted, “With the unemployment rate falling to within the range the Fed has said is consistent with full employment, and labor force participation showing no sign of picking up, it may finally be time for the Fed to call this economic recovery stable and raise rates.”

 

Some economists question whether low labor force participation — 62.6% in August — and slow wage growth — 2.2% current growth rate – reflect more room for labor market improvement. The Fed, though, has maintained a largely positive view of the job situation, alluding to how far the market has come since the depths of the recession. The unemployment rate was 7.3% in December 2008 when the Fed dropped interest rates to zero in order to aid the ailing economy. The rate would peak at 10% in October 2009.

Of greater recent concern to the Fed has been low inflation, or that the price of goods and services has not been increasing, which is viewed as a sign and necessity of a healthy economy. The Fed party line, as reflected in Fischer’s Jackson Hole speech, has been that the factors like oil’s plunge that have kept prices down should be viewed as temporary. In other words, 2% inflation is coming soon.

The Bureau of Economic Advisors reports the Fed’s preferred inflation measure, the personal consumption expenditures price index, monthly. The report released at the end of August showed prices rose 0.1% in July, down from 0.2% a month earlier. Core inflation, which removes volatile food and energy prices, was 1.2% in July, down from 1.3%.

“Both measures are well below the Fed’s 2 percent target, and are not moving any closer to it. This could be another reason for the FOMC to hold off on raising rates when it meets in mid-September,” wrote PNC Chief Economist Stuart Hoffman in a note at the time.

Meanwhile, consumer spending increasing 0.3% in July and included signs Americans are making more big purchases on items like cars. Some economists are reading the modest spending increase as a good sign. “Household income is steadily rising, and consumer spending is rising along with it as noted by solid gains in July for both personal income and consumer spending,” wrote Hoffman. He pointed to pent-up demand since the Great Recession but noted, “The outlook for monetary policy remains highly uncertain. The Federal Open Market Committee will meet in mid-September to decide whether to increase the fed funds rate; policymakers must decide whether to keep the funds rate at its current near-zero level, given uncertainty over China and the stock market, or raise rates, given solid economic growth.”

So what will the Fed make of recent market swings? The Dow Jones Industrial Average and S&P 500 Index are now both sharply in negative territory for the year, though off the correction territory lows of late August. The Vix, a popular volatility index, hit its highest level in recent memory amid the selloff. The Dow was down 1,000 points one morning last month, the largest one day point drop ever, only to cut those losses by more than 40% by the end of the trading day.

^DJA Chart

The Fed is not mandated to keep markets moving indefinitely higher but committee members have indicated financial conditions will play a role in their decision-making. One influential economist is arguing that market conditions actually make a rate hike this week unnecessary.

“Now is not the time to be hiking monetary policy,” said Jan Hatzius, chief economist at Goldman Sachs, in remarks at New York University’s Stern School of Business last week. “To a large extent the financial markets have already done all of the things that as a monetary policy maker you would hope to achieve by lifting short-term rates. If you lift short-term rates you are trying to tighten financial conditions. You are trying to put upward pressure on long term rates, you are trying to put upward pressure on the currency, you are trying to put upward pressure on the level of credit spreads and you are trying to put downward pressure on stock prices. All of those things, with the exception perhaps of upward pressure on riskless long term rates, have already happened.”

Samantha Sharf

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