Right now, markets are focused on answering one question: when will the Federal Reserve raise interest rates?
Since the depths of the financial crisis in December 2008, the Fed has kept interest rates pegged near 0%, and it hasn’t actually raised rates since July 2006.
Now, the Fed has made pretty clear that it intends to begin raising rates — what it calls “policy normalization” — some time this year.
Though following a first quarter in which economic reports widely missed expectations, some indicators pointed towards the economy showing no growth, and a March jobs report that missed expectations, the discussion has become about how long the Fed will delay before starting rate hikes.
For BlackRock’s Rick Rieder, however, the question about what the Fed does from here really has two parts: when does the Fed move and where does it go from there?
As for the Fed’s first move Rieder thinks the time is now.
“I think the Fed has an epic, historic window to move,” Rieder, chief investment officer of fundamental fixed income at BlackRock, said at a media breakfast attended by Business Insider on Thursday.
“I think people are not considering the fact that the US economy is in very good shape,” he said, adding that, “this economy today is about as good as it can get.”
In its March policy statement, the Fed effectively ruled out a rate hike at its April meeting, saying, “the Committee judges that an increase in the target range for the federal funds rate remains unlikely at the April FOMC meeting.”
This makes the Fed’s June meeting the first time it could raise rates, though Rieder said that his “base case,” or most likely scenario, for when the Fed raises rates is September.
Markets took the Fed’s March statement to indicate a more cautious approach, and market pricing all but discounted the possibility of a Fed rate hike at its June meeting. According to the latest data from CME Group, the market isn’t pricing in a rate hike from the Fed until October.
Following the March meeting, however, we argued that markets may have been misreading the Fed and discounting the idea that the Fed acts in June.
It’s a strong labour market
In his talk on Thursday, Rieder included the following chart, showing just how strong job creation has been of late compared to historical trends.
Not only have the last several years been far above average in terms of job creation, Rieder also noted that the economy has added more jobs in the last 24 months (5.5 million) than it did in the prior 13 years (4.9 million).
“This is an economy that is doing extremely well,” Rieder said, especially with respect to the labour market.
Along with its latest monetary policy statement, the Fed also released its Summary of Economic Projections, or a broad outlook for economic growth, the unemployment rate, and inflation.
In this release, the Fed lowered its long-run expectations for the unemployment rate, called its “central tendency,” to 5.2%-5% from a range of 5.5%-5.2%. This means basically that the Fed now believes the economy will be at “full employment” when the unemployment rate is somewhere between 5.2% and 5%: in March it was 5.5%.
This past week, however, we got two strong signals from the labour market. The Job Openings and Labour Turnover Survey, or JOLTS report, showing that in February there were more job openings than at any point since 2001. Additionally, the latest report on weekly initial jobless claims showed that the four-week average of people applying for unemployment insurance hit a nearly 15-year low.
Following this data, Chris Rupkey, chief financial economist at at MUFG Union Bank, wrote:
How low are unemployment claims is tantamount to asking how good the economy is. Weekly jobless claims are a leading indicator. U.S. Government guaranteed and classified. How low is 281,000? It is the lowest, the best, the economy has seen in not one but over two recessions ago … When current labour market conditions were as good back then as they are today back in 2006 even Dovish Activist Fed Chairman Bernanke was hiking rates to 5% which is a long way from 0.25% currently … There is no economic uncertainty in this number at all. The labour market is at full employment.
The inflation outlook
Federal Reserve policy seeks two outcomes: full employment and price stability.
Price stability for the Fed right now means they are targeting inflation of 2%. And it is missing the mark.
Currently, the Fed’s preferred measure of inflation is “core” PCE, which strips out the more volatile cost of food and gas, and this is running at around 1.4% year-over-year.
But for Rieder, the Fed is missing two key elements of the current economic landscape.
Technology, he noted, has put tremendous downward pressure on inflation and he thinks that because of this, we could see a situation where the economy grows with inflation lower than it has been in the past.
Rieder says that the “corridor for inflation,” or the range inside of which inflation will move, has compressed. And on a core basis, he and others have noted that inflation has been quite stable over the last 20 years — and consistently been below the Fed’s 2% target.
Which brings us to another thing the Fed is waiting for: wage inflation.
When the labour market gets “tight,” that is, when the balance of power shifts from employers to employees, economists expect that wages will increase as employers seek to retain or attract talent. And there are signs that this is happening.
Over the last several months we’ve seen big service employers like Wal-Mart, Target, TJX, and McDonald’s announce wage increases. And in his discussion Thursday, Rieder highlighted the following chart, showing that the three-month average of hourly earnings has been on the rise this year.
Now, in her latest press conference, Yellen said that wage increases would not be a pre-condition to rate hikes. But the economic idea of wage push inflation says that as workers get paid more, companies will pass these cost increases on to consumers in the form of higher prices.
And therein could lie the inflation the Fed has been looking for.
What this means for the Fed
We’ve argued in recent weeks that the Fed will raise rates in June. Markets disagree with this view.
But as we noted earlier, for Rieder, it isn’t so much about when the Fed first raises rates so much as where they are ultimately headed once they do start to move.
“Everybody is focused on the date of liftoff,” he said, “But I would argue that what’s more important is the pace and destination of rate. I think that’s a big deal.”
Given the current strength of the economy, Rieder doesn’t see the Fed moving interest rates to 1% as all that big of a deal and is something that might startle markets “for a few hours,” but will ultimately be digested and we’ll roll forward.
And really, what the Fed outlook means to you ultimately depends on whether or not you’re a bond trader, a Fortune 500 CFO, an economics reporter, or a schoolteacher.
Over the last several years, the Fed has been consistently “dovish” in its actions: waiting longer than markets expected to slow its pace of asset purchases, and now waiting longer than markets expected to being interest rate hikes. The Fed has continually stressed that it will be “data dependent” as it adjusts its current policy stance, and so the question is really how does the Fed interpret this data.
Following the release of the Minutes from the Fed’s March meeting, Rupkey wrote that change is clearly brewing inside the Fed.
“You can hear the drumbeat now as we get closer to Fed liftoff,” Rupkey wrote.
“The Fed March 17-18 meeting Minutes released after a three week lag said several members are thinking June. Wow, talk about being direct … Rate hikes are coming, very close now … They’re all talking about it, and soon it will be time to do it, just as sure as there’s smoke first before there’s fire. After reading the Minutes, we smell smoke.”
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