Expectations for an interest rate hike at the June 15 Federal Open Market Committee (FOMC) meeting quickly evaporated following Friday’s weak payroll report. Federal Reserve System (Fed) officials had been carefully preparing markets for a potential tightening of monetary policy by categorizing June as a “live” meeting. Friday’s disappointing report suggests that the labor market has softened even after compensating for the Verizon labor strike which negatively impacted the payrolls by an estimated 35 thousand jobs in May. Sluggish job gains may warrant continued caution from Fed officials as they debate the appropriateness of monetary policy next week.
Recent events make the June/July interest rate hike debate increasingly controversial. Advocates for proceeding with policy tightening tend to focus on the diminishing returns of low interest rate policies and risk of an unintended inflation overshoot. They argue that the economy can withstand another step away from zero interest rate policy. Dissenters declare the global economy as weak and increasingly at risk from U.S. policy divergence. They cite the absence of inflationary pressures as unsupportive of monetary policy tightening. Markets have taken the recent ebb and flow of policy expectations in stride. We have come a long way since the Bernanke taper tantrum disrupted global markets. Fed communication has improved considerably enabling markets to digest a full cycle of taper along with the first tightening in nearly 10 years with barely a ripple.
A pause at the June meeting would be the fourth sequential meeting without a change since the December interest rate hike. In previous meetings, the Fed was clearly concerned that global turmoil would negatively impact the U.S. economic recovery. That concern faded as global markets calmed and second quarter domestic data showed signs of firming. Fed officials then strived to ready markets for a potential resumption of the tightening cycle by the June meeting. Recent domestic data, however, fail to support arguments for policy tightening. While market conditions are very similar to the day before the last FOMC meeting in April with equity markets mostly unchanged, credit spreads modestly wider, and the U.S. dollar is slightly weaker, the trend in economic data has deteriorated. Softer labor markets, trendless inflationary pressures, and weaker purchasing manager surveys (ISM) hardly warrant concern of an overheating economy.
In fact, current conditions lead us to question the appropriateness of Fed forecasts, particularly as the span of time between the first and second hike lengthens. Initially, “gradual removal of policy accommodation” was interpreted as meaning roughly every other meeting but that was short lived. The duration of the pause has now been stretched to nearly six months leading many to conclude that Fed forecasts are overly optimistic and inconsistent with the data. Markets have persistently disagreed with the ability of the Fed to normalize policy in the current environment. The gap closed modestly following a marginal reduction in Fed forecasts in March but has once again widened in response to weak data. It will be interesting to see if the Fed’s forecasts have also evolved since the March SEP (Summary of Economic Projections) and if the gap can persist.
So what metrics are driving Federal Reserve officials to consider another tightening measure? FOMC Chair, Janet Yellen, previously indicated that the key prerequisites were continued progress toward full employment and a reasonable confidence that inflation was trending to target. In the early spring, we learned that international developments were also being considered as relevant. During the last week, several Fed officials indicated that the uncertainty surrounding the Brexit vote in June is also worthy of careful consideration. This broader focus on exogenous factors coupled with softer U.S. data appears to tip the scale in favor of an extended pause as impediments to tightening mount. However, the risk of a policy error cuts both ways. Extreme levels of policy accommodation for extended periods of time may lead to unintended consequences. …stay tuned.Download to read more