United States

Will they or won't they? Fed September rate decision looms

THE REAL ECONOMY  | 

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The U.S. Federal Reserve is rapidly approaching a major crossroad. At some point soon, the central bank will take the next step in policy normalization, embracing modestly higher interest rates for the next three years in a slow and orderly fashion. In our estimation, the case for higher interest rates remains compelling even given the recent volatility in global financial markets.

Improvement in the labor market and the strong probability that inflation will move back toward the central bank’s 2 percent target during the next 24 months are enough to support the Fed’s likely decision to raise interest rates by 25 basis points this year, followed by another 50 to 75 basis points in early 2016. After that, policymakers will probably hold off on further increases until after the 2016 U.S. presidential election. Then, in 2017, the central bank will probably get more aggressive and move rates higher on the back of what will have been a multiyear period of above-trend (2 percent) growth.

Middle Market Insight: Middle market firms will benefit in the medium term from the Fed’s return to focus on price stability as the U.S. economy experiences above-trend growth during the next two to three years.

Our estimation of the Fed’s reaction function, which explains how the central bank alters policy in response to changing economic conditions, indicates that the Fed should move to increase rates this year, with September being the preferred initiation point. While we expect that the rate hike campaign will evolve over a number of years, it is essential that the central bank gets it underway while the U.S. economy is growing above the long-term growth trend so the economy can successfully absorb the rate hikes. The alternative would mean the Fed would fall behind the curve and risk a policy error once growth has returned to trend.

While the Fed currently relies on judgment rather than a formal monetary policy rule in making decisions, a look at the traditional Taylor rule used to estimate the Fed’s reaction function shows that the federal funds rate is about 250 basis points lower than it should be. A slightly more relaxed rule that places more emphasis on labor slack, as opposed to one that focuses on price stability and maximum employment, implies the Fed should remain accommodative­—which it is given the central bank’s $4.47 trillion balance sheet and the fact that it is still reinvesting the proceeds of maturing assets.

Dueling policy rules reflect divergence of opinions at Fed

Meanwhile, data show conditions in the labor market are rapidly moving toward full employment. We think that the Fed’s estimation of the NAIRU—the nonaccelerating inflation rate of unemployment, or the level of unemployment that does not cause inflation—is 5 percent. With the economy generating, on average, a gain of 242,000 new jobs per month during the past 18 months, and the unemployment rate dropping from 6.7 to 5.3 during that span, the economy will likely move below full employment later this year or early next.

Middle Market Insight: Middle market firms will continue to find hiring skilled workers difficult, and will likely soon find even employing nonskilled workers more challenging than at any point in the recovery.

Our preferred alternative metric for conditions in the labor market, the U6-U3 spread, has declined from 6.4 percent to 5.1 during the past 18 months, just slightly above its long-term average of 4.6 percent. Even alternative estimations of the Fed’s reaction function and conditions in the labor market point to rapid improvement with a move toward full employment in the near-term. This implies a modest risk of rising inflation just over the horizon.

Middle Market Insight: The RSM Middle Market Leadership Council survey shows that firms anticipating prices paid to increase during the next six months jumped to 67 percent from 49 percent last quarter.

Recent volatility in global asset markets has caused financial conditions in the United States to tighten. Currently, those conditions are below what is considered neutral, with those in Europe and Asia considerably tighter. Indeed, if the Fed chooses to delay its liftoff, a hit to the economy via the financial channel would show up later this year if volatility continues.

However, there are countervailing forces that would likely offset that hit. If volatility continues, we expect household expenditures, which have a lag of about two quarters, to begin declining, which would subtract 0.2 percent from overall consumption, or about 25 billion. That said, the recent 30 cent decline in gasoline prices, which was delayed due to seasonal issues in the West and refining issues in the upper Midwest, will likely be followed by another 10 to 15 percent in the near-term. This would inject more than $30 billion into household balance sheets, completely offsetting the hit from a modest negative wealth effect associated with the recent decline in equity prices.

Moreover, a look at subsystems of global financial plumbing (for more see the Financial Conditions Watch on pages 5-8 of this issue) indicates little funding stress caused by the recent volatility. If indications of financial stress—for example, widening in the eurodollar spread or two-year swap spreads—appear between now and the Sept. 17 rate decision, the Fed may very well push back liftoff until next year.

At the Kansas City Fed’s annual monetary symposium Federal Reserve Vice-Chair Stanley Fischer stated that, prior to the recent market turmoil, the case for a September rate hike was pretty strong. We couldn’t agree more. In fact, we think the Fed should look past that volatility and return to making policy based on where they expect the economy to be, rather than remaining in its current data-dependent stance.

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