This week two Federal Reserve Bank Presidents spoke on the issue of monetary policy and the short-term Fed Funds target rate and both were somewhat bearish. On Tuesday, New York Fed President William Dudley, stated that, “We’re edging closer towards the point in time where it will be appropriate, I think, to raise interest rates further.” Asked if this meant an upward move in the Fed Funds target in September he stated, “I think it’s possible.” Speaking the same day, Atlanta Fed President Dennis Lockhart said he is confident growth is accelerating and he couldn’t rule out a target rate increase at the September meeting. The money markets are not impressed. The Fed Funds futures market is forecasting a 14% chance the Fed will increase rates 25bps in September.
Should the Fed raise rates in September, or at all? Well, after a weak employment report in May, the economy has responded with two consecutive very strong reports that exceeded Wall Street expectations significantly. The economy has created over 200,000 jobs a month on average, for the past year. The job market is in good shape and consumer spending has been strong as a result.
On the inflation front, and this is key for the Fed, we saw a tick-up in core CPI in the latest release this week. Core CPI, excluding food and energy prices, is running at a rate of 2.2% year-over-year (YoY). This is higher than the Fed’s target, though not by much. The Fed’s preferred measure of inflation, the Personal Consumption Expenditure deflator from the quarterly GDP report, is running at a rate of 1.7% YoY. This is a little below their target. The key is that inflation is near their target and the economy is at full employment. Maybe higher short-term interest rates are justified?
Finally, short-term growth is also impacted by productivity. While productivity is falling, our economy continues to grow at a 1-2% rate. Not great but not recession, and we may be accelerating a bit. Should we worry? Not yet, two things are happening currently to offset falling productivity. First, the velocity of money is increasing modestly. This simply means more turnover in the money supply (i.e. more lending, more spending, etc.) Second, and this is directly related to the first metric, consumer spending is strong, offsetting falling productivity. The economy does need to turn the productivity equation around but there is no urgency yet.
Here is the point. At least some members of the FOMC would clearly like to raise the Fed Funds target rate sooner than later. They may simply want to do this to normalize short-term rates now, so that they can lower them later if needed. By telegraphing this desire, these FOMC members are trying to get the market “on board” with a rate increase. They would like the market to begin forecasting more significant rate increases so that when/if they do raise rates it is not a shock. The market is not cooperating.
Another key consideration is the election. Some Fed members have stated they are not concerned about raising rates before the election. Whether they do or do not, expect one Fed rate increase before the end of the year, probably in December.
Disclosures: This piece discusses general market activity, industry or sector trends, or other broad-based economic, market , or political conditions and should not be construed as research or investment advice. The opinions expressed are those of the author and do not necessarily represent the opinions of Enterprise Bank & Trust. Past performance is no guarantee of future performance. No diversification strategy can guarantee against loss.