July 22, 2016
July 26-27 – The Fed Will Put Us on Notice for
a September 20-21 Rate Hike
The Fed was cocked and primed to deliver a 25 basis point
increase in the federal funds rate on June 15. But on June 3, the BLS announced
that nonfarm payrolls increased a paltry 38,000 in May. This monthly random
number prompted the Fed to stand down on its interest rate increase. Then on
June 23, the UK voters surprised the smart money by voting to have the UK leave
the EU. Globally, the prices of risk assets swooned for a couple of days. The
FOMC was thanking its lucky stars that the May nonfarm payroll report caused it
to hold off on its planned rate increase for June 15.
But my bet is that in the announcement immediately
following the July 26-27 FOMC meeting, the Fed will put us on notice that an
interest rate hike is on the agenda for the next FOMC meeting, September 20-21.
One reason for my Fed policy expectation is that the pace of U.S. economic
activity has picked up in recent months. June nonfarm payrolls rebounded by
287,000. Nominal retail sales surged at an annualized rate of 5.9% in the
second quarter after having contracted 0.2% annualized in the first quarter. The
manufacturing Purchasing Managers Index (PMI) increased in both May and June
with the June level of 53.2 being the highest reading since February 2015.
Corroborating the behavior of the manufacturing PMI was the 0.4% rebound in the
Fed’s measure of manufacturing production for June. At 1.160 million units,
average second quarter housing starts were the highest since Q4:2007. Too be
sure, the U.S. economy is not hitting on all cylinders. “Compression” is low in
business capital spending, in part due to the relatively low energy prices and
previously weak consumer demand. Exports
have weakened because of the slowdown in the pace of economic activity in
developing economies. But about 80% of the economy is doing reasonably well.
Does the current inflationary environment cry out for a
Fed interest rate increase? After all, growth in the Consumer Price Index (with
all components accounted for) has accelerated to an annualized rate of 3.4% in
the three months ended June (see Chart 1). But data in Chart 1 also suggest
that both the prior deceleration as well as the recent acceleration in CPI
growth has been influenced by changes in energy prices.
Chart 1
Although energy prices account for only a little bit over
7% of the CPI, in the past 12 months, the median annualized month-to-month absolute-value
percentage change in the energy component of the CPI has been almost 18%. Perhaps energy prices will continue to rise
without other prices falling, thus resulting in a still higher rate of CPI
inflation. Alternatively, perhaps energy prices will stabilize or even fall,
which, depending on the behavior of other CPI components, could result in a
decrease in CPI inflation. Perhaps some other CPI component will exhibit large
month-to-month price volatility, which translates into extreme CPI inflation
volatility. Whether it is a big movement in energy prices this month or some
other component next month, there is a lot of “noise” or volatility in the
short-term behavior of the CPI when all items are included. This makes the
Fed’s policy decisions and our investment decisions more difficult.
One way to moderate some of the noise in the CPI is to
exclude some components that historically have been volatile, such as energy
and food prices. This is part of the
logic for looking at the so-called “core” CPI – i.e., the CPI excluding its
food and energy components. But food prices and/or energy prices are not
volatile every month. So, to automatically exclude these components from the
CPI each month is arbitrary. A better way would be to “smooth” the short-term
behavior of the CPI would be to exclude items that actually are volatile in a
given month rather than arbitrarily picking one or two items that have
demonstrated price volatility in the past.
This is what the Cleveland Fed does by calculating each month something it
calls the 16% trimmed mean CPI. Essentially what the Cleveland Fed research
team does each month is trim, or eliminate, 8% of the weighted CPI components
with the largest monthly percentage increases and 8% of the weighted CPI
components with the smallest monthly percentage increases from the remaining
CPI components. Then, a weighted mean, or average, CPI is calculated using the
84% of the least volatile CPI components for that particular month. Energy
prices are not automatically excluded
from a particular month’s CPI calculation. But if the percentage change in
energy prices in a given month is extreme compared to percentages changes in
other CPI components, then they will be excluded.
Chart 2 shows the month-to-month annualized percentage
change in the Cleveland Fed 16% trimmed-mean CPI and the All-Items CPI. Not
surprisingly, the month-to-month behavior of the trimmed CPI has exhibited less
volatility than that of the All-Items CPI.
Chart 2
The Fed has hinted that its target for annualized consumer
inflation is around 2%. The median month-to-month annualized growth in the
Cleveland Fed 16% Trimmed-Mean CPI in the past 12 months has been – you guessed
it – 2%. Chauncey Gardiner predicted that the economy would grow in the spring,
and it has. The Fed has “achieved” its target consumer inflation rate. Why not
signal at the July 26-27 FOMC meeting that a federal funds rate increase is
penciled in for the September 20-21 FOMC meeting barring extenuating
circumstances?
Is it likely that the pace of U.S. economic activity will
slump significantly between now and September 21? Not if the behavior of
“thin-air” credit has anything to do with it. (Everyone may imbibe now.) Chart
3 shows that growth in the sum of commercial bank credit and the monetary base
(currency in circulation and depository institution reserves at the Fed) has
grown at an annualized rate of 4.8% in the three months ended June. Although
4.8% is not a blistering pace in an historical context, it does represent a
rebound from its growth slump in December-to-February period. The winter growth
slump in thin-air credit resulted from the Fed’s December federal funds rate
increase. In order to bring about this rate increase, the Fed had to reduce
bank reserves relative to their demand. This caused a corresponding slump in
the monetary base component of thin-air credit. As also can be seen in Chart 3,
growth in the commercial bank component of thin-air credit actually accelerated
after the Fed raised the federal funds rate in December.
Chart 3
In sum, I believe that in the policy statement of the
July 26-27 FOMC meeting, the Fed will alert us to the high probability of a 25
basis point increase in the federal funds rate occurring at the September 20-21
FOMC meeting. In the event, I believe that this will cause a significant upward
revision in market expectations of the level of future short-term interest
rates. Because yields on longer-maturity securities are a function of expected
future yields on short-maturity securities, bond yields also will rise.
Although history might not repeat itself, it does tend to rhyme. Go back and
review what happened to the bond market in 1994.
Paul L. Kasriel
Founder, Econtrarian, LLC
Senior Economic & Investment Advisor
Legacy Private Trust Co., Neenah, WI
1-920-818-0236
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