Fed Notes – July 30, 2014
The Federal Reserve met today and proceeded according to the recent plan. The taper continued, with Treasury/MBS purchases being wound down from $35 bil./mo. to $25 bil./mo. At this pace, QE Fed buys should end by October. Other comments made in the release alluded to economic strengthening, relative to the difficult winter especially, labor market improvement, but continued frustrations in housing, which has lagged it’s normal point in previous modern recoveries. Interestingly, Philadelphia Fed Pres. Charles Plosser voted against the guidance language alluding to a low Fed Funds rate for a ‘considerable time’ after QE ends, as time-dependent and not helpful considering the better conditions.
On to the decision factors and where they stand:
Economic growth: Before the meeting ended, the advance estimate for 2nd quarter GDP was released, at a reported rate of +4.0%, far above consensus of +3.0%. Strength was noted in personal spending, residential investment as well as business fixed investment. Of no real use now, revisions going back to 1999 included an improvement from the terrible Q1 from -2.9% to -2.1%. No doubt pent-up demand from weather effect accounted for much of this, but the Fed will be on watch for how strongly the economy is recovering in the second half as further ratification as to why emergency rate measures are no longer necessary.
Monetary stability/inflation/rates: Despite a tick-up over the past several months, especially on the headline side from food/energy, overall levels are contained—at least by official measures. The Fed’s preferred inflation metric, the PCE deflator, is below CPI but getting close to target, which should imply an inflection point absent other factors (see labor below). They’ve communicated a possible hike in rates sometime next year; based on what GDP has in store for the remainder of the year, the market may front-run these plans.
Employment: The official unemployment rate has declined significantly over the past several years, from the secondary recession peak of 9.8% in Nov. 2010 to 6.1% last month. The U-6 measure of ‘underemployment’ has also improved, although neither is to the point of past recovery lows or full employment (estimated to be somewhere in the low- to mid-5’s). The Fed views this as a success, but an unfinished and fragile one, especially considering that other metrics (like ‘labor utilization,’ quit rates and wage growth) are still spotty. Yellen’s pre-Fed academic focus was in the area of labor, so expect special scrutiny here.
So, the current timeline for consensus expectations is mid-2015 for the first rate hike, assuming improvement continues at the same rate. With 10-year Treasury rates at 2.5%, there doesn’t appear to be a lot of cushion built into the system for this, so a rate shock upon good news may be the path of least resistance, barring any geopolitical event and flight to quality that keeps risk-free yields low.
Stock markets had a neutral to positive response to the news, or more likely the lack of news of any language pointing to quicker rate hikes. The 10-year treasury has moved up almost 0.10% in yield following today’s GDP release.