The Case Against Fed Tightening as Soon as June
April 28, 2015
Tomorrow’s Federal Open Market Committee statement is likely to plant a strong clue if an interest rate hike in June remains a possibility. Being committed to a data-driven policy, officials will not be in a position to know definitively now whether tightening can begin at the following policy meeting on June 17, but tomorrow’s U.S. GDP report may be sufficiently weak for committee members to be quite sure that a rate hike as soon as June would be too risky.
Not wanting to surprise financial markets too abruptly, Fed officials in the past have shifted the language of forward guidance significantly at meetings that preceded a cycle of interest rate hike. The last such cycle began in June 2004, and the statement at the previous policy meeting on May 4, 2004 said, “The risks to the goal of price stability have moved into balance. At this juncture, with inflation low and resource use slack, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.” The prior statement on March 16 had instead said, “the probability of an unwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation. With inflation quite low and resource use slack, the Committee believes that it can be patient in removing its policy accommodation.”
A comparison of current and economic and financial market conditions to those existing at the start of the last four rate tightening cycles — that is, June 2004, June 1999, February 2004, and March 1988 — strongly suggests that it would be imprudent to tighten as soon as June, as doing so would carry an unacceptably high chance of having to backtrack, as the Bank of Japan and ECB were forced to do. The table below compares the present status on a number of variables — real and nominal GDP growth over the prior two quarters, the unemployment rate, on-year total and core CPI inflation, the ten-year Treasury yield, the 3- and 6-month moving average in U.S. jobs growth, and the six-month change in the trade-weighted dollar — with readings at the time when the aforementioned last four tightening cycles commenced. Real and nominal GDP, shown in the first two rows, assume quarter-on-quarter annualized growth of 0-1.0%.
| April 2015 | June 2004 | June 1999 | February 1994 | March 1988 | |
| Real GDP, % | 1.2% | 2.6% | 3.5% | 4.7% | 3.9% |
| GDP, % | 1.3% | 6.3% | 5.0% | 6.8% | 7.9% |
| Jobless Rate | 5.5% | 5.6% | 4.3% | 6.6% | 5.7% |
| 10-Yr Tsy | 1.97% | 4.62% | 5.93% | 5.77% | 8.39% |
| Fed funds | 0-0.25% | 1.0% | 4.75% | 3.0% | 6.5% |
| CPI | -0.1% | 3.3% | 2.0% | 2.5% | 3.9% |
| Core CPI | 1.6% | 1.9% | 2.1% | 2.8% | 4.3% |
| Jobs, 3 mth | 197K | 210K | 285K | 259K | 274K |
| Jobs, 6 mth | 261K | 233K | 249K | 259K | 307K |
| USD, 6mth | +11.5% | +0.8% | +9.0% | +1.2% | -10.3% |
The above table documents a much weaker backdrop from which to initiate a cycle of rising interest rates than existed for the four previous instances. Annualized real GDP growth between September 2014 and March 2015 is likely to be 1-3 percentage points lower than over the two quarters prior to the four other tightenings. The dollar on a trade-weighted basis is now 11.5% stronger than six months ago, which is likely to exert the same impact as an interest rate hike of abour 150 basis points, the point being that monetary conditions have already become considerably less accommodative. Special interest in this regard should be paid to the drag on GDP growth last quarter from net foreign demand. Such amounted to 1.03 percentage points in 4Q14. Several months beyond the ending of quantitative easing, the ten-year Treasury yield is now 265 basis points lower than it was in June 2004. The yield curve is less positively sloped than it was in the earlier instances. Total CPI inflation is negative now; in the four other cases, such was at or well above the present inflation target of 2%. Core inflation is also low. Only in June 2004 had the monthly rise in non-farm payroll jobs (210K) been comparable the the latest 3-month advance of 197K; it had been considerably greater in the earlier three episodes. And only in the case of June 1999 had the the dollar strengthened extensively six months prior to interest rate lift-off. In June 1999, however, nominal GDP had risen 5.0% annualized over the prior half year some three times faster than in current circumstances, and jobs over the latest three months posted the fastest rise of all five time periods in the above table.
The conventional wisdom holds that dollar strength will be greater the more aggressively the Federal Reserve tightens. That’s not exactly so. There are of course other factors affecting the currency markets, such as the outcome of Greek debt talks, the economic performances of Japan and China, and the upcoming Bank of Japan semi-annual economic Outlook later this week to name three. Even if the dollar’s external value were a function only of U.S. developments, its performance is more likely to be aligned with whether or not Fed policy is perceived to be appropriate. In the future, if Congressional Republicans secure the ability to micro-manage monetary policy, good policy judgement cannot be assumed. But for now, it would be very surprising in light of the above table if tomorrow’s Fed statement leaves many market players expecting an interest rate hike in June. Judging from the bond market, investors believe it’s premature to be raising interest rates as soon as mid-June. The two meetings after June’s are scheduled for July 29 and September 17. One doesn’t hear much speculation about a first move happening at the July meeting. Only by waiting until September will monetary officials have gleaned a decent idea of how strongly the U.S. economy is rebounding from the weather-depressed winter months.
Copyright 2015, Larry Greenberg. All rights reserved. No secondary distribution without express permission.
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