September Rate Rise is On - Despite What the Bond Markets Say
In the event of continued market turmoil, the Fed may push the first hike to Oct/Dec. This is a risk to our baseline.
It's getting interesting.
For some time our view has been that absent a shock or a sharp slowing in the data, the Fed would hike in September. The data are cooperating. We expect 2Q GDP growth to be revised up from 2.3 to 3.4% tomorrow and we continue to track 2.8% growth in 3Q. More important, the Fed is clearly putting a big emphasis on the labor market and they are getting just what they want.
Payroll growth has averaged 211,000 this year and shows no sign of slowing. Both the narrow (U3) and broad (U6) unemployment rate continue to trend lower, falling 0.3 and 0.8 pp respectively this year.
Inflation remains low, but "the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate."
Stripping out energy and import prices, PCE inflation is running at about 1.5% and is inching higher. As Mike Hanson has argued, the Fed seems to be relying on the job market to meet both its employment and inflation objectives.
As the markets continue to sell-off, an increasingly popular view among investors is that the Fed won't hike until next year.
Global growth is weak, Chinese policy mistakes have destabilised their markets and the US equity market has finally succumbed to the pressure, with a roughly 10% correction.
Thus far only a handful of economics teams at major houses have shifted their Fed call to next year, but both market pricing and most clients we talk to see a significant delay in Fed tightening.
We think some delay is possible, but a big delay is unlikely. It is always dangerous to make big forecast changes during periods of turmoil in markets. It is a bit like going food shopping right before dinner-your gut, instead of your mind, starts driving your decisions.
Yes, if the Fed met today, they would very likely take a wait and see attitude and delay hiking.
Why create further market volatility? Why not wait to see whether this is an economically important shock? However, there are three weeks before the Fed decides.
If the markets stabilise, the Fed outlook will feel a lot different.
Given the stark contrast between the domestic data and the markets, this is one of those moments where it is important to consider multiple scenarios:
Our baseline forecast is that markets calm over the next three weeks, data stays positive and Fed hikes in September.
Market turmoil is slow to abate, but data remains healthy, delaying the first hike to October or December. This seems like the second most likely scenario.
Market turmoil first delays the Fed, and then starts to have a significant negative impact on the macro data. This pushes out the first hike well into next year, or indefinitely.
Harvard heavy-weights
One way to underscore our view is to consider the latest perspectives from two Harvard heavyweights, offering opposite conclusions. Larry Summers argues that hiking rates this year would be a "serious error," threatening all the Fed mandates of "price stability, full employment and financial stability."
He notes that more than half of the components of the CPI have declined in the last six months, that further dollar strength could create more disinflation and that market-based measures of inflation expectations remain "well under 2 per cent."
He argues that hiking rates would "adversely affect employment levels," adding to income inequality as a weaker labor market hurts "disadvantaged workers."
Finally, he notes that while there was a financial stability case for raising rates six or nine months ago, now "markets are themselves dampening any euphoria or overconfidence." "At this moment of fragility, raising rates risks tipping some part of the financial system into crisis, with unpredictable and dangerous results." Summers underscored his concerns via Twitter: "As in August 1997, 1998, 2007 and 2008 we could be in the early stage of a very serious situation."
By contrast, Marty Feldstein argues that the Fed must stay the course. In his view, easy Fed policy has a lot more negative than positive effects.
Easy policy has caused major distortions to asset prices. Moreover, "market participants know that the economy is now essentially at full employment, that the consumer price index is close to 2% and…they know that interest rates must rise," to reverse the mispricing of assets.
Finally, if asset-price corrections have serious adverse macroeconomic effects, the task of stimulating the economy should shift from the Federal Reserve to the Obama Administration and Congress."
Who is right? Neither, as our scenarios above suggest, the Fed should and will likely start to hike rates once the turbulence in markets subsides.
Summers' wintery outlook
It is worth recalling that when Summers was being vetted as a Bernanke replacement in 2013 he was arguing that the Fed was behind the curve and should exit easy policy quickly. We disagreed with him then and we see three problems with the new super-dovish view.
First, he continues to overplay the secular stagnation argument. Since he gave his secular stagnation speech in October 2013, the economy has added 238,000 payroll jobs per month, the official unemployment rate has dropped 1.7 pp and the broad U-6 measure is down 2.7pp.
This is not a fluke: other measures of the labor market such as ADP and jobless claims have also been strong. More broadly, as we have argued repeatedly, with post-crisis healing and fewer shocks from Washington, the economy is fundamentally more healthy than it was a few years ago.
Second, he is commingling tactical and strategic elements of Fed policy. Yes, hiking into a capital markets crisis is a bad idea, but what if the crisis settles down?
Third, he is overplaying the 1998 analogy.
Growth throughout Asia collapsed in 1998, with GDP growth for developing Asia tumbling from 6.2% in 1997 to 2.7% and Japanese GDP falling 2%. Unless China collapses, nothing like that is likely today. Also the crisis had a small impact on the US economy and markets. It started with the collapse in the Thai Baht in July 1997, but did not hit the US until the fall of 1998, with the collapse of the LTCM hedge fund and the resulting freezing up of US fixed income markets.
Meanwhile the US economy cruised along unperturbed. While the US was hurt by the collapse of exports to Asia, it benefited from the drop in commodity prices and the ongoing tech boom.
Payrolls grew 264,000 per month in the 12 months prior to the freeze and 261,000 per month in the year after the freeze.
Could things get a lot worse in Asia? Our GEMs economics team thinks a regional recession is unlikely. We expect China to continue to ease monetary and fiscal policy-the 4% devaluation of the renminbi is one small step in a series of easing measures. Moreover, unlikely in the 1990s, the region has massive foreign exchange reserves to protect against a crisis.
Feldstein ahead
We are even less enamored of Feldstein's super hawkish "damn the torpedoes" approach.
He's got the cost-benefit analysis of Fed policy wrong. In terms of benefits, easy policy caused a rapid repair of balance sheets, making the economy more resilient.
It has also allowed the economy to approach full employment despite massive post-crisis and Washington headwinds. In terms of costs, it has caused only minor misallocation of resources, as evidenced by still low levels of spending in cyclical sectors.
He also glosses over the problem of persistently low inflation. The Fed's inflation target, the PCE deflator" is not "close to 2%"-headline inflation is close to zero and the core is stuck at 1.2%. Finally, anyone watching Washington knows the Fed is the only game in town.
Getting Obama and Congress to agree on a fiscal stimulus package these days is almost impossible. There is no plan B.
In sum, the market turmoil matters, but we don't want to over-react. Ultimately, the economy will dictate the Fed's exit. Hence, unless there is a big shock to US growth, rate hikes are coming as soon as the dust settles.
Finally, why is there such a big gap between pricing in the bond market and the consensus among leading economists? In our view, three things are at play.
First, the probability distribution of Fed hike is very asymmetric, with virtually no chance of an earlier move and a long tail of later moves.
Economists give their modal forecasts, while the market prices in the whole distribution.
Second, economists seem to have taken to heart the Fed's message, underscoring the labor market, downplaying current inflation readings and underscoring the relatively closed nature of the US economy.
Third, the markets seem to price in a more significant probability that the economy is suffering from secular stagnation and cannot handle even a gentle tightening cycle.