US Fed Is Preparing For Eventual Interest Rate Increase
Washington (May 21) The latest FOMC minutes for April 2015 are out on May 20, fresh out of the oven. At this stage of interest rate development, the main item of interest in the FOMC minutes is the timing of the increase of the federal fund rates. This article will include that and actually go beyond that into how the FOMC updated its view that the first quarter weakness is due to transient factors and some pointers about financial stability.
June Liftoff Unlikely
The number one question in the mind of investors right now is whether the next rate hike would increase in June or September 2015. Of course, we are now in the month of May which is 1 month after the April FOMC meeting and a series of disappointing economic reports have been released. The consensus among economists has now shifted to the September period. It would appear that the FOMC had the same shift in opinion back in April as seen in this quote below which seems tailor made to satisfy the market:
"A few anticipated that the information that would accrue by the time of the June meeting would likely indicate sufficient improvement in the economic outlook to lead the Committee to judge that its conditions for beginning policy firming had been met. Many participants, however, thought it unlikely that the data available in June would provide sufficient confirmation that the conditions for raising the target range for the federal funds rate had been satisfied, although they generally did not rule out this possibility."
The Fed has ruled out the April rate liftoff in March and they have kept their word. That was a solid promise first by Chair Yellen during the Congressional testimony and explicitly in writing in the March statement. This came out in the April minutes to say that unless there is a very strong economic statement, we are unlikely to see a rate hike next month. This would push the liftoff to September as a more realistic date where we will have sufficient data to judge if the second quarter growth managed to liftoff as it did in 2014.
Beyond the date of the liftoff, we have to look at the justification of transitory weakness as expressed by the Fed on numerous occasions. The weakness in the first quarter of 2015 is due to the unusually harsh winter. By April 2015, the worst of the winter should be over and economic data released for an objective reading of the economic growth.
Hence it should not come as a surprise that the Fed has examined the data released. The Fed confirmed its own bias of a transitory harsh winter comparing the sales figure of light vehicle sales between February and March. March sales rebounded after February sales were hindered by winter.
Winter and port strikes accounted for lower industrial production in March, which was expected to go away. However with the benefit of hindsight, we knew that industrial production weakness extended into April as well. So while it may be true that winter slowed down economic activities temporarily, there are also pockets of weaknesses in the consumption, production and even partly in the labor market.
Financial Stability and Preparation For Liftoff
One of the advantages of reading the minutes over the statement is that we are allowed a glimpse into the inner mechanism of the Fed. It is clear that the Fed has prepared for eventual liftoff . Resources have been committed to monitor the effects of higher interest rates in the economy and the mechanism of Fed tightening have been tested.
It is notable that the financial stability issues of lower interest rates, such as price bubble when savers are forced to bid for yields, were not mentioned. Instead the FOMC discussed if there will be an overreaction in the financial markets when they increase rates.
"Some participants noted the possibility that, at the time when the Committee decides to begin policy firming, term premiums could rise sharply--in a manner similar to the increase observed in the spring and summer of 2013--which might drive longer-term interest rates higher. In this connection, it was suggested that the tendency for bond prices to exhibit volatility may be greater than it had been in the past, in view of the increased role of high-frequency traders, decreased inventories of bonds held by broker-dealers, and elevated assets of bond funds."
Since the FOMC is aware of the technical difficulties that would arise from the liftoff, it is likely that they will take measures to neutralize this threat of excessive tightening. The Fed has largely concluded that tightening is in the interest of financial stability and complementary to their dual mandate.
While it is clear that the Fed would not lift rates in June, we should keep in mind that the Fed would raise rates in the near future. The Fed has prepared itself for a rate liftoff and has done its part to communicate this intention to the market in these latest minutes. The risk is that the market keeps its eye on the repeated delay in rate liftoff and forgets that the economy is in an extremely accommodative state made for a crisis situation.
This would blind them to the eventuality of the rate hike and would be too much of a surprise when it actually happens. Hence the USD would experience weakness in the near term but we should not forget the bigger picture. The USD has risen 17% since June 2014 to April 2015 even if the increases in the last 2 months (March and April 2015) were constrained. Weakness of the USD and economic data in the current month should not detract us from the overall strength of the US economy.
So for now, I am still bullish in the US economy in the medium term and it should see stronger recovery in the second and third quarter overall. However over the next 3 months, I am slightly bearish on the USD based on these FOMC minutes; notwithstanding the fact that there might be external sources of USD strength such as the recent aggressiveness of the ECB to deal with spikes in European bond yields and positive US economic data surprises.