Fed Notes: Sounds and Silence (Aug. 18)

Mike & Co.,

With the President on vacation on Martha’s Vineyard and Members of Congress back in their respective states and districts, the relative silence in Washington was barely broken yesterday when the Federal Reserve released the minutes of its July meeting of the Federal Open Market Committee.  The Committee showed divisions over whether to increase interest rates in 2016.  Some Fed officials had already signaled support earlier in the week for a raise in rates in the near future.  But the others’ silence may be more significant.

The below summarizes recent Fed developments and evaluates the indicators in tandem with other key economic trends that form the framework for the U.S. economy that the Fed applies. Note that we do not examine the activity of the Fed through the lens of the November election, as no predictable Fed action is likely to have much bearing on it.

Best,

Dana

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FOMC Minutes from July

The recently released minutes of July’s meeting of the Federal Open Market Committee (FOMC) indicate a clear split among the ten members on future interest rate action, though an overall consensus prevailed to hold the line on rates.  Two officials advocated an immediate increase in rates, but the official record showed all but only one members (out of ten) voted to keep rates steady in July.

The FOMC was less unified on whether and when interest rates should be raised during the balance of the year.  Some said they would be “open” and “flexible” about increasing rates, which could take  at any of the FOMC’s three remaining meetings in 2016, scheduled for September, November, and December.

Pet the minutes, most officials support a delay in rate increases until they see more evidence of U.S. economic strength or a rise in the inflation rate, while those supporting action in the near term cited the low unemployment rate as signifying sufficient economic health to move now.

The July minutes suggest that rates may  be increased as early as September. , the members concluded that a stronger consensus on economic outlook is needed before committing to action.  Nevertheless, clearly a majority of the FOMC believes the country, or at least the economy, is headed in the right direction.

Silence Argues for No Action

As mentioned, two Fed officials this week have suggested that market conditions have underrated a potential increase in rates in September.  On Tuesday, President of the New York Federal Reserve William Dudley stated it’s “possible” that the Fed would raise interest rates in September, citing evidence of increases in wages and a tighter labor market with the potential to increase inflation.  Dudley predicted that the U.S. economy will strengthen in the second half of 2016, and stressed the November election will play no role in the Fed’s determination of any interest rate changes.

Atlanta Fed President Dennis Lockhart confirmed that an increase in interest rates next month is in the works.  He projected that if the FOMC had met on Tuesday, “the economic data would justify a serious discussion” on raising rates in the near term, referencing gains in the job market and inflation indicators.  Lockhart added that two rate hikes in 2016 is “conceivable.”  Rates have remained unchanged since the Fed raised rates to just above zero in December 2015.

These comments come a week before the annual Economic Policy Symposium in Jackson Hole, WY.  The Federal Reserve often uses this two-day conference of global central bankers and monetary experts as a opportunity to release policy plans.  Fed Chairwoman Janet Yellen plans to attend the summit this year, after skipping in 2015.

Statements Support Preventive Action

Other economic indicators, however, paint a different picture, giving pause to assertions that a change in the interest rate will have an impact, or even occur. The persistent slow growth of inflation is one hold-up for an increase in the interest rate.  Inflation has remained below the Fed’s 2 percent target for the past four years, and has stayed constant at around 1.6 percent since March.  Job creation was strong in July, with an increase in payrolls of 255,000, but retail sales were relatively weak.

In addition, the dollar on Tuesday fell in relation to a basket of other currencies, to its lowest level since June.  This decrease took place after the statements on possible interest rate increases from the two Fed officials.

The simultaneity of these incidents is cause for concern – typically the dollar rises relative to other currencies following predictions that the interest rate will increase.  However, this requires investors to credibly believe interest rates will rise, instilling expectations that bond yields and investment returns will increase as a result.

The continued decline of the dollar despite projected interest rate increases suggests that investors do not believe the Fed will have full capacity to change policy, and will be limited by the global economic situation, specifically low overall growth.

Despite the statements from the Fed officials, those opposed to increasing interest rates may continue to delay action following these economic indicators. Short of action at the September FOMC meeting, or perhaps the later meetings in November and December, it appears we have past the point where a move by the Fed could have perceptible economic impact in real terms, or more than a fleeting impact on capital markets.  However, the fact that the Fed is discussing increasing interest rates clearly indicates their belief that the economy is moving in a positive direction.

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