Fed Note – June 18, 2014

June
19

Written by: Jon McGraw

The FOMC concluded their June meeting June 18th, again with little fanfare or surprise.

The tapering process of winding down stimulative treasury/mortgage bond purchases will continue at a rate of an additional $10 billion/mo., which will bring overall purchases down to a level of $35 bil./mo. That part came as no surprise, since jobs data, as well as several economic data points, have moved more solidly positive as a stagnant winter has been replaced by a more productive spring. Now, the committee is left (as are markets) to determine how much of that transformation is due to pent-up demand from the rough winter compared to how much is a result of improving core demand in the economy.

Other comments were focused around improved levels of growth, noting recovery from the severe winter. Consumer and business spending resumed their advance. Housing remains an area of concern; detail wasn’t mentioned, but existing home sales pricing remains high in some areas but new building demand has been sluggish.

Economic growth. This meeting featured revised data estimates for 2014 and the next several years, with the FOMC looking a bit more optimistic on 2015 and 2016. The GDP estimate for 2014 was taken down a few notches from the initial 2.9% to 2.2%. Obviously the -1% result from Q1 put a wrench in their overall plans for possible higher growth this year and even three exceptional remaining quarters wouldn’t be strong enough to fill the large gap.

Unemployment. Arguably the Fed’s primary concern at present, their assumptions have improved, ticking downward and close to the 6% pre-set threshold and perhaps into the 5’s next year. This is far better than a year ago; but at the same time (not mentioned specifically today), the Fed remains concerned about the structural vs. cyclical aspects of the current trend, low labor force participation and some skill/job opening mismatches that have been reported. These latter concerns have resulted in their reluctance to let up on the gas pedal too fast despite better headline figures.

Inflation. Releases have ticked up a bit in the last few months from the lower 1’s to 2% in the CPI this week (noting that there are operational differences between CPI and the preferred PCE deflator the Fed uses). The Fed’s assumptions remain below target, with 1.6% being the expected level for 2014, and slowly rising over the next several years. This appears to be a secondary concern at present, with job growth taking on the higher priority. They feel they have tools to control this part of the mandate should it become an issue.

Interest rates. With all the above factors combined, the consensus is for the first rate increase to happen sometime next year, with a year-end 2015 fed funds rate moving up to 1.25% (from 1.00% at the last meeting), as well as 2.50% (up from 2.25%) by year-end 2016. You might hear reference of something called a ‘dot plot,’ which is a chart showing the respective FOMC member expectations for rates going forward. As you can imagine, it is an easy way to show the spread of different opinions, but subject to change based on conditions not to mention FOMC member bias.

For portfolios? Low rates lasting longer than some predicted (and recently falling rates) have benefitted bonds; but this could be a wound spring in some segments (longer maturities), if one were to feel better economic growth is forthcoming. Continued accommodative policy is a positive tailwind for equities, that benefit from these low levels of rates/inflation by historically being assigned higher multiples. Right now, equities roughly at fair value on average, with skeptical sentiment. If conditions continue to improve, that may eventually change—but no red flags for now.