On Wednesday afternoon, the Federal Reserve released minutes from their July 28-29 Federal Open Market Committee meeting. Investors were looking forward to the minutes to discern if the Fed might start hiking rates this September, as previously expected. The minutes were somewhat muddled as they showed members continue to debate whether it is appropriate to start raising rates. But in the end, the minutes appeared to show a bias toward keeping rates low, largely due to inflation not being near the Fed’s target figure.
Conventional theory says the Fed, in trying to fulfill its dual mandate of stable prices and full employment, must try to interpret economic data to see which way the economy is tilting; is there slack in employment and therefore low rates are needed, or is inflation becoming a risk and therefore higher rates are needed? While this teeter-totter of prevailing conditions sounds good in theory, what we often find is the Fed is faced with contradictory data on economic conditions.
The recent release of July’s minutes is an example of this confusion. The Fed noted the labor markets have been improving with unemployment at 5.3%, the lowest rate so far since the recession. But historically, this isn’t that low; unemployment reached lows of 4.4% and 3.8% before the last two recessions in 2008 and the early 2000’s, respectively. Furthermore, the Fed itself admitted the labor force participation rate and the employment-to-population ratios both declined. Translation: the unemployment rate continues to decline, as less people look for work.
GDP remains tepid. Recall that growth estimates for GDP were well above 3% not too long ago, which is why many expected a rate hike as the Fed wouldn’t have as much trouble hiking rates going into a stronger economy. Meanwhile, the Fed continues to brush off the weak first half of the year as being ‘transitory.’
Inflation continues to sit below the Fed’s 2% target. The meeting minutes also labeled this as transitory, as the low inflation was attributed to lower energy prices and the decline in import prices due to past dollar appreciation.
It is clear the Fed wants to see inflation pick up to 2%. But in the minutes, they note inflation should move up to their target “with appropriate monetary policy.” This would suggest continued easy money, because tightening would cause a decline in inflation, all else being equal.
Overall, the committee seems to be split into two camps, according to the minutes. There is the camp that believes in keeping rates low because inflation is too low, and the economy is still weak, versus the camp which believes rates should be raised because they have been too low for too long already, increasing the risk of inflation or financial instability.
Readers of this blog will probably not be surprised that I am firmly in the latter camp, because the Fed artificially suppressing interest rates causes malinvestments and devaluation of the currency. However, what I believe the Fed will actually do is keep rates very low for the foreseeable future.
The reason is this. Put yourself in the shoes of the Fed committee. Instead of viewing inflation as an increase in the money supply, they only look at price increases for a basket of consumer goods, which is quite arbitrary. While this basket of goods has had relatively small price increases, other assets continue to be inflated – mainly financial assets such as stocks, bonds (especially junk bonds) and high net-worth goods like trophy real estate and art.
Second, think of the risk-reward aspect the policy makers face. If they raise rates and the economy can’t handle it, they risk bearing the guilt for crashing the economy. But if they are too slow in raising rates and inflation of consumer goods takes off, they can blame this on a host of other factors, and even cite the spike in inflation as ‘transitory’ at that time.
Finally, the other major economies of the world – Europe, China and Japan – remain weak. What is especially important is that all of these countries continue to play the game of currency wars. So even though raising rates would give the U.S. a stronger currency, which is what should be desirable, the U.S. will unfortunately feel pressured to devalue.
The markets seem to agree that the minutes favored a delayed rate hike as well. The probability of a September rate hike fell from 50% to just 36% after the release, according to traded futures. That said, the Fed could initiate a ceremonious rate increase before the end of the year, but it will be incredibly small; there is even some talk of the Fed moving to one-eighth point rate increments instead of one-quarter. This would be done to save face and give the Fed some credibility, but we will continue to be a long way from anything ‘normal’ for the foreseeable future.
Chris Kuiper CFA is currently a student and researcher at George Mason University, pursuing a Master’s of Economics. His previous experience includes asset management, investing and banking.