Yellen at the Markets: Don’t Worry. Low Unemployment to Trump Transitory Low Inflation
Fed hikes rates again, even as inflation falls further from target and financial conditions continue to ease. Smooth sailing ahead? Beware the leverage risks building below the surface.
Despite weaker economic data of late, the U.S. Federal Reserve matched market expectations in raising its benchmark interest rate June 14, 2017 a quarter point, setting its new range to a still highly accommodative 1% to 1.25%. Mattering more to markets, though, was the Fed’s updated, rather hawkish guidance of one more rate hike in 2017 and the start this year of a program to gradually trim its $4.5 trillion balance sheet. Higher benchmark rates and the slow unwinding of the Fed’s balance sheet should lift long-term borrowing costs, which have lately, somewhat paradoxically, been easing.
Interestingly, if the Fed’s language was dovish when it last raised rates in March 2017, this time around Chairwoman Janet Yellen struck a more confident tone on inflation, which has ebbed since brushing up against the targeted level in February 2017. Recent weakness has been driven by price declines in cellular service packages and prescription drug pricing, the Fed noted in its statement. In subsequent remarks to the press, Yellen suggested inflation would move back toward the 2% target given a “strong labor market,” which should continue to strengthen, she added. Unemployment in May 2017 stood at 4.3%, below the 4.5% that the Fed had been targeting this year. Yellen pointed out that the labor market participation rate, which remains quite low by historical standards, has been mostly “steady,” which is a “healthy sign,” given the growing retirement of baby boomers, she said.
To be sure, as many market participants have often noted, the Fed has rather consistently overestimated growth and inflation in recent times, and has had to subsequently reset its expectations lower, closer to market forecasts. The Fed still sees inflation hitting 2% by the end of 2018, even after lowering its forecast to 1.7% this year from 1.9% in March 2017. In its latest statement the Fed said it’s “monitoring inflation developments closely.”
But the Fed lowered its unemployment projection for this year to 4.3%, and to 4.2% for both 2018 and 2019, down from the previous 4.5% forecasts for each of the three years. Meanwhile, it lifted its economic growth projection slightly for 2017, to 2.2% from 2.1% at the March meeting, and retained its previous forecasts of 2.1% and 1.9% growth in 2018 and 2019, respectively.
“We want to keep the expansion on a sustainable path, and don’t want to find ourselves in a situation in which we’ve done nothing and then have to move aggressively,” Yellen said. The Fed is now guiding toward one more rate hike this year if the economy continues to grow as expected, and three more quarter-point hikes in both 2018 and 2019, raising the Fed funds rate to 3%, which is also its projected longer-run average.
The latest increase in the Federal funds rate marks the fourth such hike since December 2015 from a near-zero level. Even as it has raised the key rate, however, financial conditions have been easing this year. That twist echoes the “conundrum,” as former Fed Chairman Alan Greenspan put it, of the policy rate tightening in 2004 and 2005, which didn’t spur tighter financial conditions in the market, allowing leverage to continue building ahead of the 2008 financial crisis. Asked about this year’s easing in financial conditions, Yellen noted the strength in the stock market, the recent decline in the dollar, which is still “substantially” stronger than it was in 2014, and added that the Fed also takes into account other factors that don’t show up in financial conditions indices.
What she didn’t address, however, was increasing leverage, not just among businesses and public sector entities, but consumers as well. While mortgage debt is lower, student loans, auto loans and credit card balances have all been climbing, Thornburg’s Jason Brady notes. Unlike in 2015 and most of 2016, when “international developments” left financial conditions looking scary and kept the Fed on hold, this time around Europe is rebounding nicely and China is orchestrating financial market tightening at home to keep its credit issues from boiling over while so far sustaining growth around 6.5%.
While it’s reasonable for the Fed to incorporate equity market levels into its financial market assessments, the growing level of leverage in the economy should really factor into the Fed’s calculations to a far greater degree, Brady points out. A Fed funds rate slightly above 1% is still very accommodative, particularly in an economy with unemployment below targeted levels and wage growth trending higher, most recently running at an annual 3.5% on the Atlanta Fed’s Wage Growth Tracker.
Whether the Fed is behind the tightening curve and ultimately has to move “more aggressively” than it had anticipated remains to be seen. Its balance sheet reduction will also impact financial conditions, though the modest amounts of maturing mortgage and Treasury bonds that it won’t reinvest may mean that the run-off in the Fed’s balance sheet assets does proceed “in the background,” without generating much volatility and higher-than-desired long-term borrowing rates.
But incremental moves in benchmark rates amid a predictable, gradual reduction in the Fed’s balance sheet may not be the elixir needed to keep the “expansion on a sustainable path.” Economic dynamics can shift faster than consensus thinking on the Federal Open Markets Committee, not to mention the normal 12- to 18-month lag in transmission of monetary policy to the broader economy.
Inflation, unemployment, economic growth and interest rate forecasts, in this regard, are always to some degree suspect. So investors would be well advised to have portfolios built for a variety of economic outcomes, populated with individual securities chosen based on their relative valuations and attractiveness, the prospects of their issuers, and their fit within the broader portfolio. Risks, like monetary policy, may build incrementally. But unlike monetary policy, too many underappreciated risks can quickly throw markets into a tailspin. Investors who take too many risks without adequate compensation, amid rosy macro forecasts and market complacency, may well see their returns suffer if the currently richly valued market turns south.
This isn’t to suggest a repeat of the scenario a decade ago is around the corner. But the possibility that accommodative financial conditions could cause the economy to overheat and frothy financial assets to correct sharply shouldn’t be ignored. Good, risk-adjusted returns depend on that recognition.