The financial markets this afternoon read the minutes from the Federal Reserve’s October 27-28 meeting and concluded:
- That the Fed will raise interest rates for the first time since 2006 at the October meeting.
- That when the Fed says it will raise rates gradually, it means very slowly indeed.
The increased degree of belief in a December move on interest rates comes from language that the Fed inserted into its October post-meeting statement that “it may well become appropriate” to raise the benchmark lending rate in December. The minutes said that “Members emphasized that this change was intended to convey the sense that, while no decision had been made, it may well become appropriate to initiate the normalization process at the next meeting.”
According to a headcount included in the minutes, some Fed members said that economic conditions for increasing interest rates “had already been met.” Others—“most participants,” the minutes said, estimated that conditions “could well be met” in December. A third group, “some participants,” the minutes noted, “judged it unlikely that the information available by the December meeting would warrant” a rate increase.” In my opinion data since the meeting on the strength of the jobs market and the economy and on inflation have argued in favor of a December move.
Participants in the meeting “generally agreed,” the minutes said, “that it would probably be appropriate to remove policy accommodation gradually.” The minutes added, “It was noted that the beginning of the normalization process relatively soon would make it more likely that the policy trajectory after liftoff could be shallow.” After a staff briefing on the equilibrium real interest rate, Fed members discussed the possibility that the short-run equilibrium interest rate would remain below levels that were normal in previous business cycle expansions.
If the Federal Reserve’s decision on raising interest rates in December—or not—is data driven, then consider the decision done.
Today’s report from the Labor Department, showing that the U.S. economy added 271,000 jobs in October provides all the data the Fed needs to raise interest rates for the first time since 2006 at its December 16 meeting. The increase was the biggest monthly jump in 2015 and easily exceeded the median forecast of an 185,000 increase among the economists surveyed by Bloomberg. Revisions to weak August and September gains amounted to just a paltry 12,000 jobs but I don’t think that matters in the face of the October gains,
Besides the jump in employment, October also showed a hefty 0.4% increase in average hourly earnings from September. Pay for workers is now up 2.5% in the last 12 months—that’s the fastest rate of increase in six years.
The official unemployment rate fell to 5% and the full unemployment rate, which includes discourage workers who have stopped looking for work and workers with part-time jobs who would prefer full-time work, dropped to 9.8%, the lowest level since May 2008. The labor participation rate stayed steady at 62.4%.
The market reaction was predictable. The dollar rose against 15 out of 16 major global currencies. Commodities fell on the stronger dollar with U.S. benchmark West Texas Intermediate dropping to $44.46 (down 1.64%) and Brent falling to $47.59 (down 0.81%). Gold declined 1.38% and copper lost 1.5% in London.
The U.S. stock market was relatively unchanged as gains in bank stocks offset losses in other sectors. (Banks show higher profits on higher interest rates.)
Emerging market shares as measured by the iShares MSCI Emerging Markets ETF (EEM) were off 1.4%.
Is the Fed’s latest revision of its economic model pointing to a December increase in interest rates?
The decision on when the Federal Reserve will start to raise interest rates may rest with something called the output gap. And the most recent revision of an economic model at the Fed points to a December increase in rates because the output gap in the U.S. economy is projected to close in early 2016.
The Fed has released an updated version of the model of the U.S. economy put together by its staff. One key point in the model is a calculation of the speed limit for the U.S. economy. The speed limit is a projection of how fast the U.S. economy can grow before it uses up all the slack in the U.S. economy and starts to create inflation.
The newest revision puts the point where the economy will have used up that slack in the first quarter of 2016. After that quarter any increase in the speed of growth would create scarcity in such resources as workers and raw materials. What economists call the output gap—the difference between what the economy is producing and what it could produce without causing inflation—would have closed.
The newest revision of the Fed’s model of the economy estimates the economy’s speed limit at just 2% at an unemployment rate of 4.9%. The economy grew at a rate of 1.5% in the third quarter as companies reduced inventories. Real final sales, a measure of growth in the economy that excludes changes in inventories, grew at a 3% rate in the quarter. The official unemployment rate was 5.1% in September.
The approach to the point where faster growth would lead to inflation, according to the latest revision in Fed’s economic model, would certainly justify an increase in interest rates. Federal Reserve members have repeatedly noted that the time to raise interest rates is before inflation hits the Fed’s target of 2%.
If Federal Reserve policy is indeed “data-dependent” right now, this data point is signaling December.
The budget deal passed by the Senate at 1 a.m. this morning, 64-35, makes it more likely that the Federal Reserve will raise interest rates at its December 16 meeting.
How much more likely? is the question.
The deal increases defense and domestic spending for the life of the two-year budget plan and raises the ceiling on U.S. borrowing until March 2017. It puts to bed, for two years, the wrangling over the budget and the debt ceiling that had kept the possibility of a U.S. default simmering away for much of the Obama presidency.The plan would increase defense and non-defense spending by $80 billion in 2016 and 2017.
As far as the Fed and the financial markets are concerned, though, the biggest plus in the plan is certainty. For the next two years the odds are that markets, domestic and international, will hear many fewer threats to shut down the government or to let the U.S. default on its debt. The framework for the plan, with modest increases in spending and revenue should also reassure credit rating companies such as Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings that the U.S. isn’t about to go on a spending spree or austerity itself into recession. Standard & Poor’s downgraded the U.S. credit rating in 2011.
The plan balances a nip here with a spending increase there. For example on the Social Security Disability Program the Democrats got a temporary transfer of payroll tax revenue to the program from the Social Security retirement fund and Republicans got changes to the program that tighten up eligibility.
Washington being Washington, though, the deal does have its share of one-time gimmicks such as the sale of oil from the national strategic reserve. (Nothing like “Buy high” and “Sell low.”) And, of course, it uses its share of bookkeeping tricks to make the numbers add up: A $14 billion increase in defense spending isn’t included under the budget caps because “emergency” spending on the wars in Afghanistan and Iraq get their own funding line.
The deal was only possible because after announcing his resignation as Speaker of the House (and from Congress), Republican John Boehner of Ohio felt free to bring up a bill that would require votes from Democrats for passage.
Ah, so much hangs on so few words. And some digging into today’s GDP numbers.
U.S. stocks staged a very modest retreat today—the Dow Jones Industrials fell 0.13% and the Standard & Poor’s 500 dropped 0.04%–as relatively small tweaks in the Federal Reserve’s press release after this month’s meeting of the Open Market Committee raised odds that the U.S. central bank will increase interest rates at its December meeting.
Implied odds in the fed funds futures market that the Fed will decide on an initial increase in interest rates in December climbed to 50% after the meeting from 32% a week ago.
The U.S. dollar was up on the Fed’s wording; emerging market stocks fell; and commodities including copper and gold dropped.
So what did the Fed say that was enough to stall, for a day, a rally that has sent the S&P 500 up 8.8% so far in October?
How about this blockbuster change from September’s language? “In determining whether it will be appropriate to raise the target range at its next meeting, the committee will assess progress—both realized and expected—toward its objectives of maximum employment and 2% inflation.”
Spot the change? Last month the Fed’s press release did not include the phrase “at its next meeting.”
Or this one? Last month the Fed indicated that global financial and economic development might cut into U.S. growth. This time around, the Fed only said it as “monitoring global economic and financial developments.”
Of course, today’s swing in sentiment toward a December interest rate increase is stunning given the really weak headline numbers in today’s report on third quarter GDP. The topline read was that the economy grew by just 1.5% in the quarter after growth of 3.9% in the second quarter. But Wall Street quickly looked past the headline number and noted that except for a huge swing in inventories—the biggest drop in inventories since 2011 as companies decided to empty their shelves—growth in the quarter would have been near 3%. Real final sales, a number that excludes changes in inventory rose at a 2.9% pace.
This near 3% rate of GDP growth was higher than the 1.5% to 2% range forecast by some Wall Street economists in recent weeks.
Maybe the Fed is right to change its language to keep a December increase on the table.