Download The Final Countdown!

The Final Countdown!
By Brendalee Scott-Novak, CFA, FRM, MBA
Undaunted by the Federal Open Market Committee (FOMC) meeting in September, investors are
buying long-term US Treasuries in droves as the probability of a rate hike falls sharply below 30%.
Considering the significant improvements in the world’s largest economy over the last few years,
what is driving such confidence that a move by the Federal Reserve will be delayed?
The unemployment rate hit a low of 5.1% in August while second quarter Gross Domestic Product
(GDP) grew at 3.7% following a first quarter upward revision to 0.6%. This sets the tone for a 2.5%
annual GDP growth rate for 2015, much above the higher range of the growth target set by the
Federal Reserve in June. Admittedly, the economy continues to face some headwinds. July’s core
Personal Consumption Expenditure (PCE) was measured at 1.3%, significantly below the
Committee’s 2% medium term target. Coupled with the recent volatility in markets evidenced by the
VIX soaring 135% in August, the Federal Reserve is facing quite the conundrum!
The policy making body stands in stark contrast to the European Central Bank (ECB) with its dual
mandate focus; to promote maximum sustainable employment and price stability. With the
cumulative effect of a near zero interest rate policy and a bloated balance sheet of USD 4.5 trillion
(approximately 25% of GDP), one could certainly argue that the level of policy accommodation is
much bigger than initially thought. Why then does it appear that courage to lift rates is waning?
Despite the less than sanguine mood in markets recently, the employment picture remains robust.
At 5.1%, the Fed has essentially reached the levels associated with the natural rate of
unemployment. The recent Job Opening and Labour Turnover Survey (JOLTS) suggests this slack is
shrinking at an impressive rate. In July, job openings hit a record high of 5.7 million, an increase of
more than 1 million year over year. The ratio of hires to new openings further hit a pre-recession
level of 0.87 and has held steady below the breakeven rate for the last six consecutive months; a
sure sign of the shrinking slack within labour markets. Some economists have further pointed to the
non-linear relationship between shrinking slack and inflation as an economy approaches full
employment. Yet another broad measure of the labour market the underemployment rate- which
includes temporary and part-time workers, has fallen significantly to just over 10% in July from a
high of 17.1% in October 2009. The tightness in labour at this level of unemployment can quickly
transform itself into mounting wage pressure, one of the largest contributors to inflation.
Admittedly the second mandate of the Fed has been much more elusive. Whilst wage pressures
have not yet manifested into inflation, the Fed chairwoman, in her March speech cited “a substantial
body of theory and historical evidence suggesting that inflation will eventually begin to rise as
resource utilisation continues to tighten”. Not viewing the manifestation of wage pressure as a
precursor to lifting rates, Vice Chair Stanley Fischer, echoed similar sentiments late this summer. On
28 August, Mr. Fischer cautioned against the benefits of waiting too long given the substantial lag for
policy decisions to influence real economic activity.
One would also be remiss to ignore the fading disinflationary forces from a higher US dollar and free
fall in commodity prices. The implications, therefore, of mounting wage pressures as the economy
nears its maximum employment level coupled with the effect of fading disinflationary forces may be
enough to push core PCE closer to the Fed’s target.
In addition to price stability and full employment, policy makers must also keep an eye on the recent
market volatility and increasing evidence of a slowdown in China. Although the spike in the VIX was
significant, declines in US markets were less than 7% for the major indices, below what is considered
a market correction. With US exports to China at approximately 1.2% of GDP, recent market
movements are considered immaterial unless the slowdown is severe enough to threaten contagion.
Given the mixed signals of vastly improved labour markets, economic growth amidst market
volatility, and low but potentially rising inflation, there is little argument to justify maintaining an
easy money policy. Whether the policy making body can muster enough courage to increase rates in
September or December, one thing remains clear, we are on the cusp of witnessing a brand new era
in Fed monetary policy.
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the
views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the
basis of this information.
Statistics and Data Source: Bloomberg LP., Capital Economics, Federal Reserve Bank of St. Louis
Future Implied Probability of Interest Rate