01 Apr 2016 Fed Still in the Driver’s Seat
The Federal Reserve continues to be the guiding light for stock and bond investors. This week Fed Chair Janet Yellen said in a speech “Given the risks to the outlook, I consider it appropriate for the committee to proceed cautiously in adjusting policy.” Following the last meeting of the Federal Open Market Committee on March 15-16, the Fed sharply reduced its projected path of interest-rate rises this year, forecasting a total increase of half a percentage point, down from the full percentage point increase they expected in December. “The major thing that’s changed between December and March that affects the baseline outlook is a slightly weaker projected pace of global growth,” she said. “Global developments pose ongoing risks,” she added, citing specifically the dangers posed by the economic slowdown in China and the collapse in the price of oil, according to reports in the WSJ.
Yet, according to Ms. Yellen, the U.S. economy has been “remarkably resilient,” in part because markets acted like an “automatic stabilizer” and correctly read the global economic slowdown and the Fed’s likely response. “Investors responded to those developments by marking down their expectations for the future path of the federal funds rate, thereby putting downward pressure on longer-term interest rates and cushioning the adverse effects on economic activity,” she said. Notice in the chart below how much higher are the bars are on the left than the rest. They represent the heavier volume experienced during the market’s decline in January as sellers rushed to get out, reducing prices. But notice also how the market ‘quietly’ came back from mid-February on.
While there seems to be greater certainty around the pace of rate increases, there’s less understanding of how the Fed is reaching its decisions. Dana Saporta, director of U.S. economics research for Credit Suisse points out “There is some confusion about Fed policy in the sense that the Fed keeps saying it’s data-dependent and mentions specific types of data like inflation and employment and then when these indicators start to improve, the Fed doesn’t react as the market might expect. I think she is attempting to explain that surface dichotomy, and I think she was successful in it.” According to the Journal, many investors now doubt the Fed will raise rates by a half percentage point this year. They see a higher probability that rates will rise by at most a quarter percentage point by the end of 2016. If this is true, the stock market will remain the only game in town for investors for a year longer.
If there’s any doubt about how comments from Fed Chair Yellen and others of the Fed move markets, note the graphic to the right indicating the 100-point jump in the Dow Jones Industrials when the text of her speech was released revealing the Fed’s continued ‘dovish’ or shy stance on raising rates. Even though rates remain near zero, Ms. Yellen says that if the economy should take a turn for the worse, the Fed “could take steps to give it a jolt even though interest rates are still historically low. Officials could rely on public statements to reassure markets—a tool known as ‘forward guidance’—or they could launch a new round of asset purchases.” Notably, she did not include negative interest rates as a possible tool, even though other central banks in Europe and Japan are using that approach. According to the Journal, the omission could be a sign that Fed officials have closed the door on negative rates, at least for now. At her March 16th press conference, Ms. Yellen said the possibility of negative rates “is not actively a subject that we are considering or discussing.”
For now, however, the economy continues to remain relatively strong. Today’s non-farm payrolls report showed a seasonally adjusted increase of 215,000 jobs in March. The unemployment rate, obtained from a separate survey of US households, edged up to 5.0% in March. The report is not strong enough the give the Fed reason to adjust their current interest rate trajectory.
Consumer confidence grew stronger in March, according to the Conference Board. The improvement likely comes from rising stock prices after an early year scare induced by the prospect of Fed tightening (rising interest rates). Strength in stock prices seems to have overwhelmed concerns about rising gasoline prices and a mixed outlook on the pace of rising incomes. According to the WSJ, fewer consumers reported an expected rise in incomes in the next six months, suggesting to some economists why consumer spending hasn’t broken out in a meaningful way.
One of the primary underpinnings of consumer confidence is home prices. A report earlier this week indicated prices continued rising in January at a steady clip. The S&P/Case-Shiller Home Price Index, covering the entire nation, rose 5.4% in the twelve months ended in January, slightly greater than a 5.3% increase in December. The 10-city index gained 5.1% from a year earlier and the 20-city index gained 5.7% year-over-year. The hottest markets in the country, primarily on the West Coast, continued to show double-digit price gains, with Portland reporting an 11.8% year-over-year jump, Seattle showing a 10.7% gain, and San Francisco prices advancing 10.5%.
But another underpinning – household income is not rising fast enough to keep up. A Pew Charitable Trust report released Wednesday by the WSJ said “The lack of financial flexibility threatens low-income households’ financial security in the short term and their economic mobility in the long term.” Pew tracked inflation-adjusted expenditures and income of working-age Americans (20-60), from 1996 to 2014. The results show the downturn and recovery for spending in the aftermath of the 2007-09 recession but also highlight stagnating incomes (including wages, government benefits and transfers, pensions, child support and other sources).
The study reveals that the slow economic recovery from the Great Recession is leaving many behind. Pew found that as of 2014, median income before taxes had fallen by 13% from a decade earlier, while expenditures had increased by nearly 14%. That left families across the income spectrum with fewer funds for savings and investment in things like education according to the study. The study found that rent now accounts for half of the income of low-income families.
In an attempt to address problem, California governor Jerry Brown announced an increase to that state’s minimum wage to $15 by 2022. The increase is not just slated for large cities where living expenses are much higher, but in rural areas where they will have dramatic impact. According to the WSJ, California the most populous state in the U.S., with 2.2 million people earning the current $10-an-hour minimum wage. It has one of nation’s most diverse economies—ranging from the technology-rich San Francisco Bay Area to the mix of manufacturing, entertainment and low-wage work of Southern California, and the vast agricultural industry of the Central Valley.
There are always unintended consequences when free markets are interrupted by outside influences. Consider the agricultural industry in light of what we witnessed in the oil industry in the past five years. Agricultural workers are for the most part, paid at the minimum wage. Farm managers’ now realize that their labor costs will rise by 50% in the next six years. What will they do? Given that price increases will likely be constrained by competition and a not terribly strong economy, those who can will further automate and mechanize, displacing large numbers of today’s workers.
With petroleum prices pegged at excessively high prices from 2011 through 2014 by OPEC and war-constrained production, previously uneconomical oil extraction methods, like fracking and shale production, wildly expanded supplies to overflow global oil reserves and drive prices down. Similarly, higher labor expenses paid by farms make more economical the buying of tractors, harvesters, and automation equipment to improve efficiency at the expense of higher cost workers. A blanket minimum wage increase of 50% across the board in California, and possibly in New York, may well accomplish more harm to under-paid workers than it was intended to help. A stronger economy is the best way to help under-paid workers and the best way to stimulate a free economy is to remove unnecessary regulations and impediments.
The next broadcast from the Fed comes April 26th. Until then markets will have to muddle through on economic and corporate earnings reports.