What does the March rate hike say about U.S. economic health?
Review key economic indicators that caused the hike in rates.
Federal Reserve policymakers decided to raise the central bank’s benchmark federal funds rate 0.25 percent to a range of 0.75 percent to 1.00 percent today. This is the third one-quarter point increase of the current rate-hike cycle which began in December 2015. Momentum toward the decision to hike in March built quickly in Fed officials’ comments and the financial news media over a several week period beginning in late February. According to Bloomberg’s World Interest Rate Implied Probability model, the market-implied probability of a Fed rate hike in March surged from approximately 35 percent on February 22, 2017, to about 95 percent on March 3, 2017. The market is now priced for 0.75 percent of interest rate hikes in 2017, up from 0.50 percent at the end of January.
What changed over those four or five weeks that so drastically reshaped the conversation? First, minutes from the January 31 – February 1, 2017, Federal Open Market Committee (FOMC) meeting indicated that “many” Fed officials viewed an interest rate hike as appropriate “fairly soon.” The minutes cited key inflation levels approaching the Fed’s long-term 2.0 percent target and, notably, an acknowledgment that the Trump administration’s ambitious tax reform and infrastructure spending plans could lead unleash inflationary pressures. Then, several key members of the policy-setting FOMC, including Chair Janet Yellen, noted in public speaking appearances their view that the strength of economic data likely supported a higher policy rate. Importantly, during the week of March 3, 2017, two dovish Fed figures, New York Fed President William Dudley and Fed Governor Lael Brainard, also indicated an increase in the benchmark rate would be suitable “fairly soon.”
Fed governors and FOMC members described as “doves” are generally more concerned with using monetary policy as a tool to combat deflation and unemployment, and thus can be less likely to support increases in the benchmark rate. Conversely, those described as “hawks” are usually most concerned with combating inflation and a potentially over-heating economy, and can be more likely to support rate hikes. The prevailing logic across the multitudes of Fed-watchers was that if Yellen, a dove, and the dove cohort were speaking publicly about the appropriateness of a March rate hike, then it was a foregone conclusion. Chair Yellen seemed to sum up the current Fed consensus nicely during her most recent semi-annual congressional testimony in mid-February: “As I noted on previous occasions, waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession.”
Based on its March economic projections, the median Fed official estimate is for two additional rate increases (three total) in 2017, compared to just one actual increase in both 2015 and 2016. Sixteen months ago, on the heels of its first rate hike of the cycle in December 2015, the Fed estimate pointed to four rate hikes in 2016. Yet, events unfolded in a much different manner than expected resulting in only one rate hike at the very end of the year. Deflation fears driven by plunging oil prices, an unexpected British vote to leave the European Union and uncertainty leading up to the U.S. presidential election combined to throw cold water on the Fed’s original prediction. Perhaps 2017 will unfold differently.
One reasonable takeaway from the FOMC’s seemingly close to consensus view that a March rate hike was warranted is that Fed policymakers probably view the U.S. economy as increasingly robust. More specifically, in the Fed’s view, economic activity including recent payroll additions, small business hiring plans, and consumer spending suggest there may not be much slack left in the labor market. Meanwhile, core inflation trends suggest upwardly-stabilizing prices are approaching levels commensurate with a healthy economy. It is absolutely true that the national labor force participation rate remains near all-time lows, perhaps reflecting a large group of Americans that lost their jobs in the last ten years and have not returned to the workforce despite being working age. This structural shift in the U.S. labor market is serious and should not be downplayed. From a cyclical perspective, however, the jobs market appears pretty healthy. Consider that the number of so-called “underemployed” Americans (or those working in part-time jobs for “economic reasons”) is at the lowest level since 2008, while the headline unemployment rate has been halved from 10.0 percent in October 2009 to under 5.0 percent beginning in the first quarter of 2016. As depicted in the chart below, the number of underemployed workers in the U.S. economy is not too far above levels where the Fed had begun tightening cycles in 1988, 1994, 1999 and 2004. In her March 3, 2017, speech at the Executives Club of Chicago, Chair Yellen provided an update on her view of the Fed’s dual mandate of maximizing employment and stabilizing inflation: “…the economy has essentially met the employment portion of our mandate and inflation is moving closer to our two percent objective.” One of the most recent (and powerful) indications of a strong labor market were the 298,000 jobs created in the private sector during February. This reading marked the highest monthly reading since 2014 and the third-highest monthly reading since 2007. Last Friday, the U.S. Labor Department weighed in by reporting total non-farm payrolls (private and public) grew by 235,000 in February, while the headline unemployment rate ticked down to 4.7 percent– its tenth consecutive month below 5.0 percent.
Turning to inflation, the Fed’s stated preferred inflation measure is a data series called U.S. Personal Consumption Expenditure Core Price Index or Core PCE. This reading excludes volatile energy and food prices in its basket of consumer purchases. A healthy level of inflation is considered a critical component of a well-functioning economy, as it implies demand for goods and services is strong enough for companies to increase prices, grow revenues and reinvest back in their business through capital investment and hiring workers. The Fed’s stated target for the year-over-year (YoY) change in Core PCE is 2.0 percent. Since the official beginning of the Great Recession beginning in December 2007 to January 2017, there have been just 14 months out of 110 during which Core PCE YoY was above 2.0 percent. In other words, since 2009, the Fed has been fighting a mostly losing battle against deflationary forces, which can be just as damaging as the inflationary price instability seen in the 1970s. As seen in the chart below, the recent trend of YoY Core PCE has been creeping upwards close to the Fed’s stated 2.0 percent target. This is encouraging from the Fed’s perspective; especially considering deflationary forces subdued this measure of inflation below 1.5 percent for all of 2015.
From 2014 to 2016, several unanticipated events led to lower than-anticipated inflation and growth expectations, in turn making the Fed proceed very cautiously. These included the oil price collapse, significant dollar appreciation, a slowdown in the Chinese economy and Great Britain’s decision to leave the European Union. As 2017 begins, it seems that those mostly deflationary headwinds might be in the rear view mirror. Ironically, a new set of inflationary challenges for Fed policymakers might arise this year and beyond. The Trump administration’s stated pro-growth agenda includes plans for significant corporate tax cuts, foreign profit repatriation at favorable tax rates, significant import taxes and potentially deficit-fueled spending on national infrastructure programs. All of these policies would most likely be inflationary if implemented. The Fed’s most recent step to wean the U.S. economy off low interest rates has occurred in a different economic and political environment than the first two rate hikes of December 2015 and 2016, respectively. A cyclically-strong U.S. labor market, stabilizing consumer price trends, and a tamer U.S. dollar have aligned to create an environment in which Fed policymakers see the economy as strong enough to digest its second quarter point rate hike in three months and project two more hikes for the next nine months of 2017.