Fed rate hike Wednesday? Markets say yes, data say no
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As increasingly pronounced weakness and ample uncertainty appear to be seeping into the latest round of economic figures, the Fed may have a more difficult time than previously anticipated justifying a rate hike this week. Investors, however, appear undeterred by the lack of stellar data, continuing to expect a second-round 2017 policy adjustment on Wednesday with near certainty. 

Although the market appears to be giving policymakers the green light to move ahead with the second hike this year, at least some members on the Federal Reserve will likely question the Fed’s policy pathway as the economy and inflation appear to be underperforming relative to the Federal Open Market Committee’s (FOMC) latest projections. 

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In other words, the latest slowdown in prices and growth suggests policymakers should err on the side of caution, holding policy steady rather than accelerating the removal of accommodation. But, without clear indications of perpetual weakness — or an acknowledgement of such at this point — and a lack of conviction among the doves, the Fed may simply remain on auto-drive, fueled by pre-established momentum to higher rates with the market’s blessing. 

 

The Fed’s justification for higher rates in the near term has been increasingly pegged to prices rising back toward the Fed’s 2-percent inflation target as the primary motivation for action. After all, few data points outside of inflation have supported the notion that a further rise in rates was appropriate, let alone near-term. 

Now, with inflation rapidly cooling, can the Fed still justify a rate hike this week? At this point, some FOMC members are likely wavering on what is the appropriate action. However, those on the fence may also be willing to temper said concerns at this point while conditions remain moderate.

In other words, officials will be balancing the relativity of today’s loss of momentum against the backdrop of potential improvement down the road in the ongoing battle of choosing the glass through which to view the economy: half-empty or half-full. 

First, growth has slowed but remains in positive territory. Second, employment gains have weakened and wage growth has stalled somewhat but overall earnings remain minimally improved from the stagnant near-2-percent pace established in the aftermath of the Great Recession.

Third, domestic manufacturing activity — as reported by the Institute for Supply Management Index — has slowed from a recent peak of 57.7 to 54.9, but the 2017 average of 56.12 remains above the pace of activity in the prior year. Fourth, while inflation has moved well-below the Fed’s 2-percent target, current price measures are still amply improved from the lows reached 10 months prior, and deflationary fears have not yet reemerged. 

In other words, things could be a lot worse and may in fact get worse. Thus, those Fed officials more concerned about the downside risks for growth and inflation going forward may be less vocal this month, waiting for further evidence of weakness before digging in their heels on policy and conceding to the notion of accumulating additional ammunition in the Fed’s toolkit to eventually combat economic weakness on the back end.   

Which brings us back to the initial question: Is there enough justification for the Fed to raise rates Wednesday? No; not if one is looking solely at the economic data.  But, there aren’t necessarily clear and distinct reasons not to raise rates this week either. It would seem that both sides are in need of further data and evidence to support their proposed policy pathway. 

At this point, however, with the underlying momentum of the Fed erring toward higher rates, the hawks may simply overpower the doves at this week’s discussion.  With an equal lack of clear defensible data or conviction on both sides, it may simply come down to expectations — not the Fed’s expectations but the markets’. 

It’s difficult to imagine that Fed members wake up in the morning and turn on CNBC to see the investor-approved pathway for policy, but it does appear to be increasingly the case, at least as of late. The green light from the market, justified or not, may be just enough ammunition to push through another rate hike, even without the data to back such a decision. 

Of course, as long as inflation remains “soft" — or gets softer still — and the potential of pro-growth fiscal policy remains but a figment of the imagination, not to mention an increasingly contentious world amid ongoing geopolitical risk, interest rates on the longer end of the curve will continue to compress. 

As we have long contended, the majority of the run-up following Trump’s election was the result of unfounded optimism regarding a potential pro-growth agenda.  Underlying fundamentals, however, remain moderate at best, and relatively little changed from the third quarter of 2016 when the 10-year Treasury bond was trading at 1.60 percent. 

This pressure will eventually limit the Fed’s ability to continue to raise rates, particularly given a good portion of the FOMC's motivation to elevate Fed funds may simply stem from wanting to rebuild the monetary policy toolkit.  

Lindsey Piegza, Ph.D., is the chief economist for Stifel Fixed Income. She has had her research published in Harvard Business Review and in textbooks for Northwestern University's Kellogg Graduate School of Management. She's a regular guest on CNBC, Bloomberg, Fox News and CNN.


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