By Lance Gaitan
All signs pointed to a quarter-point rate hike coming from the Federal Reserve’s monetary policy arm, the Federal Open Market Committee (FOMC). That’s exactly what we got after its two-day meeting ended yesterday.
The rate hike applies to the overnight federal funds rate that banks pay for borrowing to meet their reserve requirements.
Remember, the Fed’s dual mandate – handed down by Congress in 1977 – is to promote stable prices and maximum employment through monetary policy actions.
In that vein, the Fed assumes that a rate hike will trigger a complex chain of reactions.
These ripples will influence other short-term interest rates, exchange rates, long-term-interest rates, and credit availability. The Fed’s rate decisions can also affect a range of economic variables, including employment, output, and the prices of goods and services.
(Maybe the rate hike will also give us an extra week of vacation? Sheesh.)
That’s a wide array of assumptions and forecasts, all things considered. With a track record as dicey as the Fed’s, I can’t help but see it as overly ambitious…
See, the Fed assumes its rate hikes extend through the “curve” (also called the spectrum) of Treasury debt, from short-term to long-term bond prices. Put another way, the assumption is that an overnight rate hike affects all borrowing costs.
As you can see in the chart below, it doesn’t always work out that way…
Notice that in the aftermath of five out of six rate hikes since December 2015, long-term Treasury yields actually fell in the weeks and months following the action! (December 2017 was the one exception.)
It’s too early to say how long-term yields will react to yesterday’s move.
Let’s take a look at recent economic data, starting with releases that the Fed monitors closely. The past week and a half has brought a lot of good news…
April personal income was up 0.3%, which was in line with expectations. Consumer spending, on the other hand, doubled the consensus forecast and came in at 0.6%.
The April personal consumption expenditure price (PCE) index, the Fed’s preferred inflation gauge, was up 0.2% month over month. That number held at both the headline level and once food and energy costs were removed. The market had expected 0.1% on the latter reading.
Year-over-year core inflation was up 1.8%, in line with Wall Street’s consensus view.
Spending surprised to the upside, and inflation tracked the market’s expectations.
The good news kept coming in the May jobs report.
The consensus expected a 190,000 increase in monthly non-farm payrolls. It got 223,000. On top of that, the unemployment rate dipped unexpectedly, moving below 3.8%.
Most important, earnings were up 0.3% on the expectation of a 0.2% rise.
One month of data does not make a trend. However, consumer inflation has started to show up in core prices, with wages and spending moving higher.
Fast-forward to the May Consumer Price Index (CPI), which came out on Tuesday. Core CPI (less food and energy) was up 0.2% for the month; on the year, the index was up 2.2%, just above the Fed target of 2%.
Yesterday’s release of the May Producer Price Index (PPI) also came in hot. Prices were up 0.5% on the month, compared to expectations for a 0.3% rise. Core prices were up 0.3% on an expected 0.2% increase.
On top of yesterday’s rate increase, the Fed signaled two more hikes for later this year. That outlook came as a bit of a surprise. If the economy slows, the risk of the U.S. slipping into recession would increase.
I’ll continue to monitor the yield curve, which is the difference between short-term Treasury yields and long-term yields.
If long-term yields fall below short-term yields, our economy will likely fall into recession. In fact, every recession since 1955 has been preceded by a negative spread between the 10-year Treasury note and the one-year Treasury bill.
(The difference between a bond, a note, and a bill is simply the time needed for maturation. A bond matures in 10 to 30 years; a note in two to 10 years; and a bill in a year or less.)
U.S. economic growth likely has peaked, so I see the uptick in inflation as a transitory phenomenon that might hang around for three to six months. Our friends at the Fed have used “transitory” to describe something that lasts a couple of years.
The central bank often uses this qualifier when it talks about a lack of inflation – whatever it takes to put a positive spin on things, right?
If the economy weakens sooner rather than later, inflationary pressures will recede, wage growth will falter, and the Fed probably won’t stick with its plan to hike rates twice more this year.