FOMC Holds Rates Steady; Details Economic Progress

As expected yesterday, the US Federal Opens Market Committee (FOMC) held interest rates steady with the target range between 0.25% and 0.50%.  One sign of the weakening of the Fed's resolve at maintaining the status quo, however, came with Esther L. George's dissenting vote.  As noted in the formal announcement, the traditionally hawkish George preferred to increase the federal funds rate to 0.50% to 0.75%.  She was outvoted 9-1.

The language and tone of the announcement demonstrated a subtle shift towards a tightening policy, however. Respective to the Fed mandate of maintaining full employment, they said, "Information received since the Federal Open Market Committee met in June indicates that the labor market strengthened and that economic activity has been expanding at a moderate rate. Job gains were strong in June following weak growth in May."  

Given the very robust jobs report in June, that position is not surprising.  Indeed, the standard unemployment level has been sustained below 5% for several months, although it's equally important to note that over 94 million Americans are now unemployed - the highest number since the Labor Force Participation Rate has been maintained. 

If the job market were the only factor under consideration, there's little doubt that the Fed would be moving to raise interest rates.  The stumbling block continues to be inflation.  The all-items CPI for urban consumers is 1%.  The FOMC target, however, is 2%, and there's little indication that inflation will reach that target in the short term.  They acknowledged that yesterday, saying, "Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further." 

They did not define "medium term" in this context, however Janet Yellen defined it in 2009, saying, "From macroanalysis, I consider short term as referring to less than, say, a year or two, medium term as ranging from around two to six years, and long term as anything beyond around six."  Read into that what you will, since the ultimate question will be whether or not the Fed will raise interest rates before inflation reaches the 2% target.  If that target is not anticipated for at least another two years, then we've a long ways to go before we see any monetary tightening.

The June announcements were rife with caution, citing potentially permanent "headwinds" and some rather dire forecasts regarding the global economy. This month's announcement shows a complete reversal of those ominous undertones.  "Near-term risks to the economic outlook have diminished. The Committee continues to closely monitor inflation indicators and global economic and financial developments."

What they classified as "near-term risks" was not expounded upon, however it's reasonable to assume that they are referencing the unknown impacts of Brexit, a strong US dollar, and the prospect of recession in Europe.  While the Brexit impact is certainly moved out into the distant future - at least 2019 or beyond, even if the UK invokes Article 50 next year - and Europe appears to have inched ever so slightly away from recession, I find it hard to dismiss the impact the strong US dollar is having and will continue to have for the foreseeable future.  It's doubtful, however, that the dollar alone will be enough to stay the Fed's hand.

Interestingly, the markets appeared to treat the FOMC release with a yawn.  The Nasdaq Composite was up both yesterday and today, and the S&P 500, while down a hair yesterday, recovered it today to continue it's horizontal correction without giving or gaining any ground. 

Equally interesting, the Fed Fund Futures still show only an 18% chance of a rate hike in September, and the chance of a December hike dropped to 36.8%.  In fact, you have to go all the way out to June 2017 before the chance of an increase even reaches 40%.  Clearly, the market is factoring in very low interest rates for at least the next year.  The 10-year Treasury Yield is still declining, dropping to 1.52% today, which would be another possible indication that rates will continue low for some time.  (It's also a further indication of a flight to safety, which is a warning of potentially troubled times ahead in the equities markets.)

The Fed summed up a very dovish posture once again, stating, "The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run."  That view, however, is not consistent with the "dot plot," an estimation of where FOMC members view interest rates over the next several years.  A solid base of participants forecast one additional rate hike in 2016, however the strongest dot concentration shows two rate hikes, presumably in September and December with the average rate falling between 0.75% and 1% by year end.

The next FOMC meeting is September 21st, so we have almost 8-weeks before the next rate decision is expected.  A lot can happen in 8-weeks, and there will be two more major economic data points available to the Fed before that decision is warranted.  What we as traders need to watch, however, is the potential for good economic news to become bad for the market.  A very strong jobs report, or a healthy uptick in inflation could signal that there is a greater potential for a September rate hike.  That would send stocks tumbling once again, hence the good news is bad phenomenon.  Exercise caution around major data releases since the reaction will be somewhat unpredictable for the time being.

With regards to monetary policy, we now turn our attention to the Bank of England and next Thursday's Monetary Policy Committee announcement.  Stay tuned.

Happy Trading.