Pity the poor Federal Reserve. In making decisions about interest rates–in this case about whether or not to raise interest rates at its June, July or September meetings–it has to consider the condition of both the real economy and the financial markets.
And right now the two realms are sending out different signals.
The real economy seems to be in good shape, the disappointing 38,000 increase in jobs in May not withstanding. The financial markets not so much so.
You figure out how the Fed is going to split the difference.
In the real economy today’s report from the Commerce Department showed that retail sales in May grew by a better than forecast 0.5%, after a 1.3% increase in April. (The April gain was the biggest in a year.) The means retail sales have now posted their best back-to-back monthly gains in two years. Wall Street analysts have moved today to increase their estimates for annualized growth in household spending to 3.7% from 3.4% (Barclays), and 3.6% from 3.2% (Credit Suisse.) Household spending grew by just an annualized 1.9% in the first quarter.
Absent a surge in job growth, the big increase in retail sales and household spending is coming from wage growth. The economy may not have created many jobs in May, but companies aren’t laying off many people either and they’re paying more to keep their current workers on board.
The Federal Reserve Bank of Atlanta’s wage growth tracker shows wage growth accelerating since October 2015 to a pace not seen since January 2009. The median U.S. worker saw a 3.5% year over year pay increase as of May. That is another indicator that the U.S. economy may be nearing full employment. Anecdotal evidence from individual companies is that finding quality employees is a getting harder with the NFIB Small Business Optimism report for May putting the share of owners unable to fill a job opening at historically high levels.
On the other hand, financial markets struggling. U.S. stocks have pulled back (as expected) from an attempt to set an all time high on the Standard & Poor’s above 2135. More worryingly, the spread between the yield on 10-year U.S. Treasury notes and two-year notes is the narrowest since 2007. Such flattening of the yield curve can signal an impending recession. Deutsche Bank analyst Steven Zeng, for example, now puts the odds of a U.S. recession at 55% within the next 12 months. If that’s a real possibility, the last thing the Federal Reserve would want to do is potentially accelerate the arrival of a recession by raising interest rates. I think there are good reasons to think that the bond market signal is wrong. The big moves along the yield curve are also responding to changes in demand for different maturities of Treasuries because of new financial regulations and worries over the Brexit vote in the United Kingdom on leaving/staying in the European Union. Money is sloshing around seeking safety in a world with major financial uncertainties.
That’s my sense of the signs at the moment. The situation is very fluid. Uncertainty is high. And that in itself is likely to lead the Federal Reserve to wait before making any decision. The Fed’s next rate setting meeting is scheduled for Wednesday June 15.
On Wednesday the Federal Reserve will release the minutes from its April meeting–against a background set by today’s release of numbers showing stronger than expected wage and inflation growth.
The wage growth figures come from the Federal Reserve Bank of Atlanta’s wage growth tracker, which some economists on Wall Street believe gives a more accurate picture of wage growth than the average hourly earnings data published by the Bureau of Labor Statistics. The Atlanta Fed’s model showed a 3.4% year over year increase in pay as of April. That’s the highest rate of wage growth since 2009.
Today we also got the Consumer Price Index inflation rate for April. The headline CPI climbed at the highest rate in three years. Consumer prices increased by 0.4%, the biggest gain since February 2013. (Consumer prices rose by 0.1% in March.) Core inflation, which strips out changes in the prices for food and energy rose by 0.2% after a 0.1% gain in March. The biggest contributor to the jump in headline inflation was higher gasoline and energy prices with gasoline prices showing the biggest increase in four years.
Unfortunately, the April Fed minutes set for release on Wednesday won’t tell us what Fed members make of this new data. Certainly strong wage growth argues for the strength of the U.S.economy and for an interest rate increase sooner rather than later. The CPI inflation data cuts two ways in my opinion. (The Fed does not use the CPI as its inflation measure but this index does generally point in the same direction as the Fed’s preferred inflation measure.) On the one hand, higher inflation suggests a need to raise interest rates so that inflation expectations don’t get out of control. On the other hand, higher energy costs are a kind of tax on the U.S. economy and the Fed may figure that rising prices for energy are enough to slow the economy without the added burden of higher interest rates.
Right now the Fed’s Funds futures market is pricing in just an 11.3% chance for an interest rate increase at the June meeting–but that’s still up from just 3.8% yesterday. Odds on a July increase have climbed to 30% from 20.5% yesterday and for the September meeting to 47% from 39.1% yesterday.
The Fed minutes, though, are likely to tell us how much weight the Fed is giving to worries about volatility in global financial markets–with those markets firming, the more worry the Fed felt in April, the more likely an interest rate increase. Any clues on what the Fed is thinking about Brexit will be welcome since Britain holds a referendum on staying in or leaving the European Union just a week after the Fed’s June meeting. The more worry in the minutes about Brexit, the less likely the Fed is to increase interest rates in June. Also look for any clues that the Fed was inclined to look past first quarter weakness in the U.S. economy as just more of the recent pattern of weak first quarters in years posting decent growth for the 12-month period.
The longer the financial markets thought about the actions announced by the European Central Bank today, the less impressed markets were. The STOXX 600 Europe Index had climbed as much as 2.5% during the day, but after peaking around 1 p.m., the index finished down 1.7% for the day. The French CAC 40 ended lower by 1.7% and the German DAX was off by 2.3% at the close.
The problem was that European Central Bank President Mario Draghi undercut, as far as the market was concerned, more forceful than expected action with his comments to reporters. The bank announced another 10 basis point cut to its overnight deposit rate to a negative 0.4% (as expected); raised the amount of assets it aims to buy each month to 80 billion euros from 60 billion (10 billion more than expected) and that it would add corporate debt to its potential purchases.
Nothing startling there but more than expected.
But Draghi then said that the central bank is done–at least for a while. “From today’s perspective, we don’t anticipate it will be necessary to reduce rates further,” he said. The package “is an adequate reaction to a weakening of the growth and price-stability prospects,” Draghi added. “We think the measures we took today are adequate to address the change in economic conditions that occurred since our last monetary policy meeting.”
Which seems puzzling since he also noted that inflation is expected to remain negative (deflation in other words but without saying the “d word) in the coming months but will pick up later in 2016. (Inflation in February was a negative 0.2%.) The central bank lowered its inflation forecast for 2016 to 0.1% from the 1% forecast in December. Inflation will climb to 1.3% in 2017 and then 1.6% in 2018.
Last time I checked the math 1.6% is still less than the 2% target the bank has set as a goal for its program of asset purchases. And the bank is now projecting that inflation will remain below that target through 2018.
The European Central Bank also cut it forecast for economic growth in the EuroZone to 1.4% in 2016. That’s below the 1.7% growth in GDP the central bank forecast in December. The EuroZone economy will grow by 1.7% in 2017.
So let’s see–inflation lower than the target and economic growth tepid into 2017. Yep, I can see why the European Central Bank announced that it was done for a while.
On the news the euro climbed to $1.1207 against the dollar–after falling by as much as 1.6% earlier.
The most important take-away to me from today’s announcement and the market reaction is that traders and investors are becoming increasingly skeptical about the ability of central banks to stimulate higher growth and to generate higher inflation.
The bag of tricks announced today by the European Central Bank didn’t contain anything new and the same old, same old–even more of the same old, same old–doesn’t have the old magic that it once did.
Call it “Whatever it takes” II.
Today, European Central Bank President Mario Draghi said that the EuroZone central bank “will do what we must to raise inflation as quickly as possible.”
I don’t expect that this promise, made in a speech in Frankfurt, will have the same electric effect as “Whatever it takes” I in July 2012. That promise reversed a plunging euro, pulled the bonds of Spain and Italy back from the brink, and set the stage for a significant recovery in the prices of euro assets.
This time I think the likely market reaction will be positive—that is the euro will move lower as the bank wants (it closed at $1.0656 down 0.68% against the dollar today) and financial assets will move higher (the German DAX is up 0.31% today)—the move will be much more modest. The likely actions from the bank are relatively modest in contrast to past proposals and the problems the central bank faces have proven to be very resistant to the bank’s solutions to date.
After today’s remarks by Draghi pretty much everyone has concluded that the bank will move at its December 3 meeting—even though hardline members of the bank’s board of governors such as Germany’s Jens Weidmann are saying no changes are needed now. The bank’s inflation target of 2% remains a distant dream with the current inflation rate in the EuroZone at just 0.1%.
The policy menu in front of the bank includes an expansion of the current program of bond buying from 60 billion euros a month to 80 billion or so; an extension of the life of the program beyond the current September 2016 limit, and a further drop in the bank deposit rate. In normal times the central bank pays a modest rate of interest on money that banks leave on deposit over night. These days the central bank charges banks that leave their money overnight 0.2%. It’s just about certain that the European Central Bank will take that negative deposit rate even lower to, say a negative 0.3%. Bond yields across the EuroZone are already falling even further into negative territory in anticipation of the central bank’s move. The yield on 2-year German government bonds fell to a record low of a negative 0.389% today.
There is a good possibility that rather than choosing from this policy menu the European Central Bank will implement all of these items. That would still fall well short of a “shock and awe” response to the current mix of extremely low inflation and tepid growth, but at this point it might be the best the European Central Bank can do.
Inflation in China at the consumer level rose in October at just a 1.3% rate year over year. That, the National Bureau of Statistics said on Monday, was the lowest rate since May and well below the 1.6% rate in September. Economists had expected an increase of 1.5
A truckload of implications (or at least five) follows from this number.
First, combined with the disappointing showing on exports and imports in data released over the weekend, it reinforces forecasts of slow growth in the global economy. The fear of slow global growth has led to another day of declines in emerging markets. The iShares MSCI Emerging Markets Index ETF (EEM) was down another 0.38% on Monday.
Second, with inflation in China so low, the People’s Bank of China is relatively free to cut interest rates, reduce bank reserve requirements, and otherwise stimulate growth in the Chinese economy. I think the Chinese markets will start to anticipate some or all of those measures in fairly short order. (Think possible short-term rally.)
Third, with low or no inflation in the global economy, there isn’t anything that I can see that stands in the way of a stronger U.S. dollar. (The U.S. dollar, in fact, hit a six-month high against the euro on November 9).
Fourth, with a stronger dollar and lower global growth expect weaker commodity prices. Oil was up slightly today as of 3 p.m. in New York time after days of decline but copper was down 0.47%.
Fifth, a stronger dollar means more cash flowing into dollar assets, which is likely to damp increases in U.S. interest rates when/if the Federal Reserve moves. The yield on the 10-year U.S. Treasury held steady on Monday at 2.31%.