Benjamin M. Lavine, CFA, CAIA
Source: iStockphoto.com. Used with permission.
Yes, these words proved to be inauspicious for our last two presidents. But Federal Reserve Chairperson Janet Yellen can declare these words with greater confidence as the Fed contemplates exiting the emergency zero-rate policy set by her predecessor, Ben Bernanke, at the December 15-16 policy-setting meeting. The Federal Reserve, under Ben Bernanke, enacted emergency monetary policy measures following the 2008 global financial crisis which included expanding the Federal Reserve Balance Sheet (Quantitative Easing) and dropping short-term interest rates to near zero (December 2008). Consider Ms. Yellen’s congressional testimony on December 2nd. She communicated a “gradual path” of Fed rate increases as Fed officials have acknowledged some lingering headwinds to economic normalization such as the strong U.S. dollar, stubbornly low inflation, and remaining slack in U.S. labor markets. Indeed, the markets expected the Fed to raise rates back at the September meeting but were negatively surprised by Federal statements pointing to “market turbulence and global developments” (read China) as the basis for not raising rates. At the October meeting, the Fed put a December rate hike back on track as they clarified their outlook. Now, Fed Funds futures are pricing in a 75-80% probability that the Fed moves off the zero-rate policy with a 25 basis point rate hike followed by another rate hike expected between March and June 2016 (Figure 1).
Figure 1: Fed Funds Futures Expect 25 Basis Point Rate Hike
The Fed can justify its upcoming rate hike, despite “market turbulence and global developments”, because it has achieved its dual mandate of full employment and price stability. Leading employment indicators such as cycle highs in NFIB hard-to-fill survey and cycle lows in U.S. jobless claims reflect robust employment conditions (Figure 2). Core CPI remains muted at 1.9% for the year ending October and has remained at or below 2% since September 2012. There are some signs of a build-up in wage pressures, which could pose a problem if productivity does not improve (Figure 3). However, the Fed can afford to be more “patient and gradual” in this next rate hike cycle versus prior cycles, because there are few signs of inflationary pressures or credit bubble formations that warrant a more aggressive pace.
Figure 2 – NFIB Small Business Jobs Hard to Fill and U.S. Jobless Claims (4-Week Moving Average): Labor Conditions Suggest Fed Has Met Full Employment Mandate
Figure 3 – NFIB Small Business Compensation Plans (SA) and US Productivity: Employers Signaling Wage Increases Which Would Need a Commensurate Raise in Productivity for It to Be Non-Inflationary
Too Early or Too Late?
As with our current and previous presidents, the Fed runs the risk of running into a policy ‘quagmire.’ By insisting on moving forward with a rate hike, the Fed is largely ignoring much of the recent market volatility and turbulence coming from the commodity and credit markets (see 3D’s November 2015 Market Commentary). In addition, the Fed will take the unprecedented step of raising rates in the face of:
- Possible earnings and revenue recession (3Q2015 S&P earnings declined 1.3% and revenues declined 3.9%);
- Declining operating margins;
- An inventory build-up that will serve as a drag on near-term economic output;
- A continuing slowdown in China (latest trade report reveals a significant slowdown in exports and imports); and
- A possible slowdown in consumer spending (some early indicators such as department store commentary, retail traffic, and credit card transactions point to less-than-robust holiday shopping season).
Some are worried that the Fed may be ‘behind the curve’ having argued that the Fed should have raised rates sooner. The 2/10-year Treasury bond term structure continues to flatten with short rates rising and long rates falling, whereas the typical pattern is for the curve to steepen before the start of a rate hike cycle. Despite few signs of inflationary pressures building up, market-based inflation expectations have been slowly rising even though expected long-term inflation is still below 2% (Figure 4). Both of these indicators suggest that the Fed may be too late in raising rates, which could result in the worst-case scenario of stagflation. However, unless other input cost pressures start to build up (i.e. commodity prices), this is an unlikely scenario, but one investors should be conscious of.
Figure 4: 5-Year/5-Year Forward Breakeven Spreads (Inflation Expectations) and 2-10 Year Treasury Term Structure: Rising Inflation Expectations and Flattening Yield Curve Point to Stagflation
Period Ending 11/30/2015
A Break from the Past
There could also be a psychological reason for wanting to declare ‘Mission Accomplished’ next week, and that is to break from the past, namely the emergency rate policy established by Ben Bernanke. Next week’s meeting presents an opportunity for Ms. Yellen to break with the rate policy of her predecessor and establish a new course for the Fed, even if it continues to trek into uncharted territory. Why continue with an emergency policy if economic conditions are normalizing? Moving off the zero-rate bound will serve as the first tangible signal of confidence from the Fed that the U.S. no longer needs monetary life support. Hopefully, a rate hike cycle, no matter how patient and gradual, will not send the patient back to the hospital.