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Market View

The U.S. Federal Reserve will cite economic data, but the real reason for a rate hike may have more to do with having the tools to fight the next economic downturn.

The U.S. Federal Reserve (Fed) has named a number of factors that could lead to a decision to hike rates sooner rather than later, including inflation expectations, the outlook for commodity prices and the U.S. dollar, indicators of increased wage and labor costs, and concerns about the financial distortion from keeping rates too low for too long. One concern not often talked about is the prospect of the Fed running out of the monetary tools used to mitigate a potential economic slowdown. With some Fed studies putting the effectiveness of quantitative easing in doubt and with interest rates at close to zero-bound, the Fed may need to hike rates regardless of what the economic data indicate. 

Elsewhere in the world, China scored a considerable public relations coup when the International Monetary Fund (IMF) voted to include the Chinese currency, the renminbi (or yuan), in its basket of reserve currencies (which includes the dollar, the yen, the British pound, and the euro), known as Special Drawing Rights (SDRs). Was this just a political move by the IMF? After all, with China the world’s largest economy, at least measured by purchasing power parity, some say that the IMF would lack global legitimacy if it did not give a leading role to the yuan. And will this recognition help to extract more needed market reforms out of Beijing, as the IMF hopes?

Addressing these and other topics are Lord Abbett Partners Zane Brown, Fixed Income Strategist; David Linsen, CFA, Director of Research; and Milton Ezrati, Senior Economist and Market Strategist.

Q. We’ll know soon enough whether the Fed will raise rates this year or next, so the next debate most likely will center round the question, “At what pace?” Certainly, we’ve seen the first issue debated publicly among members of the Federal Open Marketing Committee [FOMC], the policy-making arm of the Fed. Why has the FOMC had such a difficult time with this decision? 

Zane Brown: From the perspective of the markets, the very open debate between the Fed “doves,” who favor a continuation of low rates, and the Fed “hawks,” who want to see a normalization of those rates, has been a great source of volatility. But I think it’s helpful to frame the debate within the context of what the Fed has remaining, in terms of monetary tools, to influence the economy. And the answer to that is, “Not very much.” They’ve tried quantitative easing [QE] to boost the economy, but separate Fed studies—one from the New York Fed and the other from the St. Louis Fed—have concluded that QE has accomplished very little. Should another economic slowdown occur, the Fed will not have the ability to use its other tool of monetary policy, lowering interest rates, since rates are already close to zero bound. Hence, the pressure from the hawks to get rates back on the path to normalization.

Milton Ezrati: That’s correct. In addition to those two studies, the FOMC’s own research staff also concluded that QE hasn’t helped. And it’s clear from testimony by Fed chairwoman Janet Yellen that the chief motivation of the Fed in raising rates is not to restrain the economy, which is the usual intent of a rate hike, but rather to normalize rates in order to have a monetary tool available to use in the event of an economic slowdown. She’s used the term “normalization” on numerous occasions. Ultimately, her hand will be forced; the Fed will hike rates whether the economy is strong or weak.

David Linsen: But normalization is tightening.

Milton: Yes, relative to where rates are now. But I would argue that the Fed is right to say “normalize.” We’re no longer facing an emergency. And even if the FOMC were to raise the target fed funds rate by 25 basis points [bps], to 50 bps, that’s hardly restraint. It’s still less than the rate of inflation.

David: With GDP [gross domestic product] growth rates so tepid here in the United States, not to mention around the globe, wouldn’t any form of tightening have a negative effect?

Milton: Maybe not. Research coming out of the Fed indicates that a small rate hike would not have a negative effect on the U.S. economy. Of course, the Fed could be wrong, and we could be heading for a train wreck.

Zane: That brings us back to the debate between the hawks and the doves. According to the Fed doves, if you tighten now, you run the risk of pushing the U.S. economy into another economic downturn. The Fed hawks make the point that rates have been low long enough. Anyone who would benefit from low rates has already benefited. Companies and consumers have refinanced their debts, for example. But banks still aren’t lending. Moreover, if you keep rates where they are for a longer period of time, it doesn’t really guarantee that you’re going to get GDP growth greater than 2–2.5%. That’s all we’ve been able to extract over the last couple of years. Some also argue that the Fed wants to eliminate what’s been deemed “financial repression,” especially for U.S. savers, who get no return from money market funds and essentially nothing from bank deposits. One could take exception to some of those arguments. But those are the views commonly expressed by FOMC members in favor of raising rates.  

Milton: The hawks’ argument has also been supported by another FOMC staff report, which concluded that keeping rates at these low levels indefinitely distorts fundamental investment decision-making in the United States.

Q. Last month, Fed officials said that before they raise rates, they would need more confidence that higher inflation was in the cards, especially since the central bank has missed its 2% target rate for more than three years. But long-term inflation expectations are at their lowest point since 2007, according to the Philadelphia Fed. What are the data telling us, and how will that affect the Fed’s decision to hike rates?

David: Lower commodity prices have been pushing down headline inflation, as measured by the CPI [Consumer Price Index]; but excluding food and energy, which are the two most volatile components of CPI, so-called “core inflation” is up 1.9% year over year, October 2014 to October 2015.  

Zane: That’s right. And since most members of the FOMC view the impact of volatile energy and commodity prices as transitory elements in the equation, their focus is on core inflation.

Of course, the Fed eventually is going to look at headline PCEP [Personal Consumption Expenditure Price Index], which measures the percentage change in prices of goods and services purchased by consumers throughout the economy. But Fed officials view the PCEP as an indicator of where core inflation is heading. And it seems to be heading up, although it is still below their target rate of 2%. At just under 2%, the Fed would seem to have room to raise rates very gradually, without the risk of raising prices, while still keeping rates at relatively low levels over an extended period of time.      

Q. What are some of the elements of core inflation that the Fed is watching closely?

Zane: The Fed’s focal point, time and time again, has been the inflation associated with labor costs. Wages are a focal point as a core component of inflation, primarily because wage-related costs are the hardest to unwind. Commodity prices are more transitory. And monetary inflation is something supposedly under their control. So, something that would lead to eventual inflation is rising wages, and wage growth over the last year recently moved up from around 2% to 2.5%, according to the Bureau of Labor Statistics.

Milton: Most of the growth has been in high-skill jobs. Low-skill jobs are stagnant. So, it’s a tough one for the Fed, because while the growth rate on average is accelerating modestly, it’s not really widespread throughout the economy.

Zane: The Fed claims to look at a variety of labor indicators, but the leaders of the Fed, including Yellen, all have some belief in a modified Phillips curve, which suggests that there is an inverse relationship between inflation and unemployment. They believe that as the labor market gets tighter and tighter, that leads to more inflation, and one key indication of that is the JOLT [Job Openings and Labor Turnover] survey, a monthly survey done by the U.S. Bureau of Labor Statistics that measures job vacancies.

In 2009, the JOLT survey showed that there were 6.8 applicants looking for every job. Today, it’s down to 1.4 to 1. Historically, anytime we’ve gone below 2 to 1, we’ve started to see wage inflation six months later. So I think they may be looking at JOLT as an indicator that at some point fairly soon, we're going to get increasing wage inflation.

If wage growth continues at 2.5%, it will pull up the rest of inflation. That’s what the hawks are likely to use as their rationale for getting back that policy tool of higher interest rates.

Milton: The hawks also could use the rising U.S. dollar as an excuse and say that a) the dollar is keeping wages and inflation down in the United States, which compounds the effect of lower commodity prices on inflation (even though commodities are typically quoted in dollars), and b) this situation is not going to go on indefinitely—i.e., the dollar will not always rise, and commodity prices are a transitory part of the inflation equation. 

Q. Looking at wage and labor costs, then, which number will the Fed cite as its primary indicator of a need to hike rates?

Zane: If they really need their interest-rate policy tool back, which I believe they do, they’re going to build a rationale around the change in the total nonfarm payroll employment number. That number increased by 271, 000 in October, after dropping below 200,000 in September and August. November’s number, released last week, remains just above 200,000 at 211,000, and that may provide the FOMC with enough of a rationale for a rate hike. They’ll call the drop in August and September temporary and cite wage inflation as a concern long term.

Milton: Let me just add that the Fed also knows it can’t play this game forever. It’s under some constraint because of the election year. It can’t go too far past March 2016 in its decision to hike rates, because then the options will start closing and it will  be accused of politicking.

Q. We’re all assuming that the next Fed move will be to hike rates. But for a moment let’s consider the study issued by the San Francisco Fed that states that monetary policy may actually be too contractionary, at least in terms of the so-called “natural” interest rate. That would certainly support the doves’ argument that rates should stay low, and even support those who claim that rates should be negative.

Milton: Knut Wicksell, a leading Swedish economist in the late nineteenth century, created the concept of a natural rate of interest, which he defined as the fundamental real return of investment in the economy—that is, the peoples’ perception of what they can make on their investment going forward in real terms. Then, if there’s inflation, that just adds to the number. I don’t think the statistical model used in the study captures what Wicksell was talking about.

The study says that the real rate of return on investment falls in recessions—what a shocker! And of course in this abysmal recovery, the real rate of return on investment is going to be substandard. Again—what a surprise. But Wicksell really was talking about the fundamentals in the economy. Now, maybe you could say that the fundamentals have radically changed since the Great Recession of 2008–09, and that the real rate of return people can expect on their investments is so reduced that now it’s a negative number. But if you believe it’s a negative number, then what you are saying is that, fundamentally, the world’s economies are returning a loss on investment, that the world economy is shrinking. That’s what the logical conclusion of the study is. And if you believe that, then yes, the Fed had better not raise rates. But I don’t know if I agree with that.

Zane: On that point, then, the implication is that we shouldn’t have zero rates in the United States, we should have negative rates instead, which would, theoretically, provoke more investment and less savings. Yet that concept does not seem to be working in Sweden or in Europe, where you do have negative short-term interest rates.

In Sweden, for example, short-term rates have been at -75 bps, and they still have 7% unemployment, according to the Financial Times. So I think the results of this theory have been somewhat questionable, at least as they’ve been put into practice.

Milton: If we really believe that the U.S. economy needs negative rates, then we have bigger problems than monetary policy.

Zane: The other side to that argument is that San Francisco Fed governor [John] Williams and others have stated that even with all the things that have been unfolding over the last month or two, a rate hike may be appropriate soon.

Milton: The Fed’s credibility is at stake here, too. Yellen will look like a fool if she eventually says, “I was wrong.”

Q. What about Fed governor Lael Brainard’s comments that just talking about rate hikes has been the equivalent of two rate hikes anyway?

Zane: The ECB [European Central Bank] has certainly demonstrated that [ECB president Mario] Draghi has moved the market more by talking about policy than by actually changing policy. And in the United States, the two-year Treasury note has moved noticeably higher in yield, without an actual hike in the fed funds rate, although rates on longer maturities have not followed. Thirty-year mortgage rates are almost unchanged versus six to 12 months ago

Milton: Certainly the economy doesn’t seem to have acted like rates have tightened. It hasn’t done well, but there hasn’t been a particular downturn in the economy.

Q. Is the Fed, meanwhile, taking China into its considerations?

Milton: I’d be surprised. In my experience, and I’ve never attended the meetings, the Fed has never looked abroad, it’s never even looked at currency. It looks at inflation and it looks at the economy. That’s its mandate. If the dollar’s weak, that’s not the Fed’s issue. If the world needs our help, that’s too bad.

Zane: Now, the Fed did cite China and the global economic slowdown—but in the context of how it would affect our growth, our outlook for employment and inflation. And there are a few members in particular that are concerned about the strength of the dollar and how it affects earnings and inflation here.

Q. Speaking of China, the IMF announced that it will be adding the Chinese yuan to its elite basket of reserve currencies, the so-called Special Drawing Rights [SDRs]. What do you think of this decision?

Milton: Including the yuan among the SDRs is recognition of political/economic reality. China is a major trading country, although the yuan is not as heavily traded as even the British pound. As I’ve mentioned elsewhere, this latest move by the IMF will hardly make the yuan a contender for the dollar’s role as the world’s reserve currency.

Zane: The IMF’s decision was widely expected, but the rationale hints more of politics than integrity. Instead of recognizing a freely tradable currency that is used increasingly in global transactions, the IMF decision was designed to promote liberalization of still-rigid currency regulations in the hope that a freer trading currency and more transparent financial markets will at some point result. It seems that inclusion should be recognition of the importance of a currency to global trade, not a vehicle to force government changes to get the currency where it needs to be. The action is a nod of respect to the global trading power of China, but the yuan seems unlikely to become a freely traded and widely used currency anytime soon. If that were to happen now, China would risk a flight of capital out of the country as investors fear an economic slowdown in that country.

Q. According to Morgan Stanley, emerging markets [EMs], including China, account for 52% of global GDP. How much of an impact do the slowing EM economies have on the United States and the eurozone?

Zane: Certainly more of an impact in the eurozone than in the United States. U.S. exports are 13% of U.S. GDP, while Germany’s exports, for example, are 50% of its GDP, according to the World Bank.

Milton: The economic slowdown in China has had a major impact on the German economy, far worse than what the U.S. economy has experienced.

But I would add, given what the ECB is doing, global liquidity will not suffer if the Fed raises rates a quarter of a percentage point. The ECB is pouring money into the markets. In the EMs, it’s a liquidity issue, not a dollar-liquidity issue. Other than that, EMs, by and large, are sellers, not buyers.

Zane: They’re sellers oftentimes of commodities and, to a lesser extent, finished goods. To the extent that we import from them, a stronger U.S. dollar means that what we import is going to be cheaper; and you’ll have the same impact with lower commodity and oil prices. As we import cheaper goods, you end up with more purchasing power here, so you could make the argument that any weakness in those countries—because we import more than we export—actually may help our economy by increasing purchasing power.

Q. Have we seen evidence of that? 

Zane: We have been expecting that increased purchasing power and the impact from lower oil prices would be evident in more consumption. But we haven’t seen that yet. Instead, consumers have been paying down debt.

Milton: Mortgage debt especially. But the amazing thing is that the consumer has saved every penny of the break in oil prices. Not literally, of course, but if you look at the aggregates, it equates to more than a 5% pay raise for the average American—and all they did was put it into savings. According to the Commerce Department, the consumer has brought the savings rate down from 5%, which is high from an historical stance, to 4% or 3.8%; but during different quarters, it has gone back up to 5%. Consumers seem to be scaring themselves into frugality.

Zane: That’s true—they haven’t been spending as much as we expected them to. Nonetheless, it creates the opportunity for more purchasing power and maybe boosting GDP.

David: U.S. consumers may not be spending as much on retail goods, but clearly we see increased spending on durable goods [i.e., products expected to last three years or longer].

Zane: You’re right—autos, durable goods, housing. Autos in particular—sales have gone up and stayed up and continue to go higher.

I have a feeling that at some point we’re going to discover that baby boomers, as they continue to approach retirement, are going to decide that they don’t need more “stuff,” that they don’t want to invest anymore because they no longer trust investments—and that they want to pay off their debts, especially their mortgages. But I’ve not seen any analysis of that.

Milton: That would be really hard to find in the data.

David: That trend—moving away from owning stuff to having experiences, such as going on cruises, staying at hotels, taking the family out to restaurants—has been going on for some time. So, consequently, we’ve seen restaurant sales improve dramatically, but retail sales somewhat less so.

Milton: That would be consistent with baby boomers who are not building a household and collecting stuff. And I thought fun ended after 60.

Q. What can consumers expect in terms of future oil prices?

Zane: I think the idea of oil returning to $80 per barrel in the next couple of years is fairly remote. The United States is now a major supplier of oil. Yes, we’re now shutting down some wells, but we’re shutting down the inefficient wells and the inefficient drills.

There will be so much shadow inventory available once the price of oil does go higher, that I think we have the potential to become a much larger supplier of oil than we are already. And because of that additional supply, any dramatic price improvement will likely be capped.

Milton: Still, 30–35% of the world’s oil passes through the Persian Gulf. And that means it’s very vulnerable to geopolitics. If things get worse in that part of the world, then oil prices will go up. All this is to say that we’ve probably already seen the lows. A rise in the price of oil will either be a very gradual climb or there will be a geopolitical problem—and then we’ll see a spike.

Zane: The new supply pressure that’s likely to come online over the next 12 months will be from Iran.

Milton: Yes, because of the nuclear deal, they can sell more. But of course they were selling it on the black market anyway.

David: The big event is what OPEC [Organization of the Petroleum Exporting Countries], and specifically Saudi Arabia, wants to do with their supply. They made the decision last November to continue production at a high rate, which took the price down. Prices have remained depressed throughout this year because of excess supply. At their most recent meeting last week, they made no change to that decision. The question is, how long will it take to eliminate the higher marginal cost producers? When global supply moderates, we should see higher prices over time. 

Q. Are we entering a profit recession?

David: In some sectors, we already have. Specifically, in the energy, materials, and parts of the industrial sectors, earnings have decreased meaningfully. But in other parts of the economy, such as health care, consumer discretionary, and technology, the market is experiencing decent earnings growth. Energy, materials, and some industrials—that is, the ones leveraged to emerging markets and commodities—will have less support from a growing U.S. economy than the consumer discretionary, financials, healthcare, and technology sectors.

Milton: And if you eliminate the hard-hit commodities sector, the S&P 500 had a pretty good quarter.

Zane: Some sectors may be in a profit recession, but we are not in an economic recession. U.S. GDP growth is still positive, after all. Let me suggest, though, that an earnings recession is much more problematic in China, and maybe much more likely in China, than what we have in the United States. Here, it’s been isolated to certain industries. But in China, a slowdown in exports, because of the slowdown in global growth, will mean a contraction in jobs.

Q. Thank you, gentlemen.

 

Market forecasts and projections are based on current market conditions and are subject to change without notice.

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