In our research publications we aim to provide you with insights from a variety of different viewpoints while maintaining an official Cambridge view on asset allocation and portfolio construction in our quarterly VantagePoint publication, written by our Chief Investment Strategist. In this edition of C|A Answers, two members of our Capital Markets Research team debate the pace of future rate increases.
Sean McLaughlin: No, it’s too slow. Federal Reserve interest rate normalization will likely begin earlier and will advance more quickly than the market anticipates. The market’s expectation for the Fed Funds rate is considerably more dovish than the forecasts provided by members of the Fed’s policymaking Open Markets Committee (FOMC), and it’s also more dovish than recent economic data call for.
Even as it prepares to conclude its bond-buying this month, the Fed continues to spike the punchbowl via near-zero policy interest rates. While some employment weakness remains and recent inflation levels remain below the Fed’s target, economic data over the past 12 months indicate that the economy no longer requires stimulus levels that were unimaginable until the global financial crisis.
Fed Funds futures contracts imply that the policy rate will end next year at 0.5% and will end 2016 at 1.4%, much lower than the median expectation from FOMC members of 1.4% and 2.9%, respectively. The market’s expectations show the policy rate remaining below 2% until September 2017. This would equate to more than eight years of sub-2% policy rates. Prior to 2001, sub-2% rates were almost unheard of, but since that time, they have held sway a stunning 66% of the time. Investors and the economy have gotten quite used to the extraordinary stimulus regime during most of the past 13 years, but the economy today would survive a Fed move to a more neutral posture over time.
Unemployment in September dropped below 6%, from a high of 10% five years ago. To be sure, today’s 5.9% level is higher than the median post-war level of 5.6%, and plenty of Americans remain out of work. But the economy appears to have sufficient momentum to continue to improve with a lower level of stimulus. While some groups (including young people and those without college degrees) still face high unemployment and underemployment rates, joblessness across most demographics has declined sharply from its 2010 peak level, and in many cases is not far above pre-recession levels.
Dovish investors point to the dwindling labor-force participation rate as a primary cause of falling unemployment; however, this trend appears unlikely to reverse and flood the job market with prospective workers anytime soon. Fully 46% of small businesses surveyed in August reported that they received few or no qualified applicants for posted positions, versus less than 35% on average since the end of the recession in 2009. Even the most comprehensive unemployment rate (the Labor Department’s U6 rate, which includes the traditionally measured jobless population, plus enforced part-time workers, plus “discouraged workers” who have not searched for work within the latest month but who would be available to work) has dipped below 12% from a 2010 peak of more than 17%; it is currently equal to the level from January 1994, when the Fed Funds rate was at 3% and rising.
In fact, today’s sub-6% unemployment level is consistent historically with a near-term increase in the Fed Funds rate. Looking back at periods of falling unemployment dating from the 1950s, when levels were below 6%, more than two-thirds of the time the Fed Funds rate increased over the following six months. Current Fed Funds futures markets indicate stable rates through the end of June 2015, which would be a longer-than-typical wait to raise rates.
Wage growth and inflation are low; the Fed has little pressure to act to restrain price pressures. However, the timing is ripe for the Fed to shift into neutral, even if “neutral” today may imply a lower rate than it would have during higher-inflation periods.
If the Fed continues to maintain a highly stimulative near-zero policy rate, it would have diminished flexibility were the economy to weaken unexpectedly, and it would need to again resort to quantitative easing or other non-traditional measures. On the other hand, if the Fed were to move to a more neutral policy over the near term, it could then turn to traditional policy actions when they eventually become necessary to influence growth and price stability. The housing market and economy today can withstand a more neutral policy stance, and this stance would return to the Fed a policy tool it has not had in its arsenal since 2008—the tool of further lowering policy interest rates.
Eric Winig: No, it’s too fast. The Fed has backed itself into a corner where it can’t raise rates, although it would very much like people to think it will. People have been predicting the Fed would raise rates for the past several years, and just as those recurring January forecasts of a “second-half recovery” have been consistently off the mark (and look to be again this year), so will predictions of the Fed raising rates.
The fact is, as much as the Fed talks about wanting to raise the policy rate, it may very well not be able to. First, the (substandard) economic growth that currently exists is almost entirely tied to low rates—driven by housing and autos. For the former, mortgage applications just touched their lowest level since 2000 despite 30-year rates being a mere 4.25%, and for the latter, subprime car loans now make up nearly one-third of overall loans—and subprime originations are at an eight-year high—with an average length just shy of six years. Higher rates could severely damage both sectors.
Even in the unlikely event US growth takes off, the Fed has other impediments to raising rates. The IMF recently ratcheted down its global growth forecast (again), and deflationary pressures continue to mount in much of the world. Given the interconnected nature of today’s global economy, it’s (a) hard to imagine US growth accelerating while the rest of the world stagnates, and (b) near impossible to consider the Fed raising rates in the face of a global deflationary downturn.
Along similar lines, while my colleague’s historical data seem convincing at first glance, the key ingredient not addressed is whether we should expect the future to resemble these periods. While that could be the case, the current environment is of course different in many respects. Perhaps the most striking example of this is in the labor market, where the headline unemployment rate continues to drop—and an increasing number of companies complain about not being able to find qualified workers—even as people leave the workforce in droves.
Thus, the question that should be asked is how to square these seemingly contradictory data points. Part of the answer may well be the recent explosion in government benefits—e.g., roughly 50 million people receive food stamps today, nearly double the 2008 level, while disability payments have also skyrocketed, with more than 20 million people now receiving some sort of federal benefit. Additionally, the number of people out of work for more than six months—the government’s definition of long-term unemployed—is a historically high 3 million. (For context, the current “working age” population, i.e., those aged 15-64, is just over 200 million.) In addition, and related, is the fact that most good-paying jobs—those that would be more lucrative than government benefits—now require technical skills that many job seekers do not possess.
So while companies may indeed be having trouble finding qualified workers, this has far more to do with a skills gap and that many people are simply choosing the dole over a job than with a booming economy driving up demand for labor. Sean mentions that few jobs have been created for young people (most of recent job growth has been in the 55+ age group), but not the related issue that real wages are basically stagnant. The Fed has rarely, if ever, raised rates without a preceding rise in wages, and doing so risks placing the average worker in more difficult straits financially.
The Fed’s current lack of flexibility is a real issue, but may ultimately prove irrelevant. While central bankers would always prefer this policy flexibility, they have backed themselves into (as one wag put it) the mother of all painted-in corners. To wit, any effort to raise rates may impact risk assets directly and with some force, thus causing the Fed to reverse course. This is exactly what has happened at the end of each successive round of quantitative easing—as soon as QE ended, risk assets swooned and the Fed was forced to step in with yet another program.
The reason the Fed keeps talking about raising rates is it plays into the story that economic growth is recovering; the theory seems to be that the Fed can extricate itself from this predicament by igniting Keynes’ famous “animal spirits.” Count me skeptical.
Finally, the Fed itself has recently said it is not sure how it will raise rates given its historical vehicle—overnight lending between banks—has been obviated by the (Fed-driven) rise in banks’ excess reserves. In other words, since banks no longer need to borrow overnight from each other, there is no rate for the Fed to influence. The Fed’s plan is to use the interest paid on excess reserves, with reverse repos as a backstop, but as St. Louis Federal Reserve Bank President James Bullard recently noted, “We’ve never done this before, so we don’t know exactly how it will work.”
Reassuring words.
Sean McLaughlin and Eric Winig are Managing Directors on the Cambridge Associates Global Investment Research team.
For more on term structures and what level of rates the US economy may support, please see our September 2014 research note, How Far Will US Rates Rise in The Next Cycle?.