Markets have priced in a high probability of a December rate hike. But is the US economy ready for an interest-rate liftoff?
It would be an understatement to say that all eyes are watching the Federal Reserve to see if December will bring its long-awaited rate hike campaign.
The market has priced in a 68% probability of a December hike, up from about 50% prior to the last employment report. Even with about a two-thirds chance, this is still enough uncertainty to keep investors guessing for the next few weeks as we await further reports such as Black Friday/Cyber Monday sales, November’s employment report and October’s employment revision.
So how should investors feel about the increasing likelihood of a hike? In situations like these, a little context can be helpful.
During every business cycle, the Fed plays an important role. Many people complain that the Fed has never accurately called a recession or recovery in advance and it is too reactionary. To me, this is not really the Fed’s job.
Instead, the Fed’s mandate is to smooth out the end points of booms and busts in order to limit the extremes. Specifically, it is the Fed’s obligation to be the lender of last resort in times of distress, so we don’t have extended or severe downturns.
Conversely, it is also the Fed’s responsibility to “take away the punch bowl” of easy money when corporations, banks and consumers get carried away and start doing dumb things. However, to call a recession prematurely can quash the economy’s potential while stimulating too soon can leave it with excess capacity, thereby stunting the recovery it is trying to foment.
Fed officials constantly tell us they will be “data dependent” in setting monetary policy. This has led to higher volatility in financial markets around key economic data releases. To wit, the Nov. 6 employment report resulted in a two-standard-deviation move (-4.2%) in the price of 10-year US Treasury bonds, perhaps the most liquid market in the world. Did the fundamentals really change that much on the back of one month’s employment data? I seriously doubt it, especially given that most of these reports are revised significantly in the following months.
What about the larger question of whether the economy can handle a tightening? A little context is also helpful here.
First, while the federal funds rate is still officially at zero, it is hard to argue the Fed hadn’t already started tightening monetary policy when it ended Quantitative Easing (QE) last year. We can see this explicitly in our Morgan Stanley Financial Conditions Index, which tightened meaningfully in 2014 as QE was winding down. The Fed itself has published a paper suggesting that the strength in the US Dollar over the past year, as a result of QE ending, is equivalent to 150 basis points (bps) of Fed Funds rate hikes.
Second, while many market prognosticators and traders continue to fret over the Fed’s first rate hike (while getting whipped around daily by the newest dose of data), I believe the Fed has been extremely focused on the numbers and essentially right on schedule with prior cycles insofar as its dual mandate of full employment and price stability, which for now, is a 2% inflation target.
The chart below illustrates this last point. Notice how the employment gap has steadily declined during the past seven years. Based on this measure, there is now no slack left in the labor force. This is something the Fed watches closely in determining if it is meeting its mandate on employment.
Source: Bloomberg, Haver Analytics, Morgan Stanley Wealth Management GIC as of Oct. 31, 2015
An employment gap at zero argues we are already close to full employment. Whenever the employment gap has gone this low, wages have typically followed and started to move up. That, too, is happening now. Wages are an important part of inflation, which is the Fed’s other mandate.
Clearly, we have come a long way since the Great Recession and, based on the data, it is starting to look fairly clear that the Fed should be tightening.
In the past, the Fed has typically started its tightening campaign before the employment gap reaches zero or wages quarter turn positive. This is shown by the vertical red lines. The red line in the current cycle coincides with the ending of QE, which we have always viewed as the first tightening.
Unsurprisingly, the red line appears when the employment gap reaches about 1%—i.e., before all of the slack is gone and wages increase too rapidly. This cycle was no different except that wages actually were improving at a faster rate than prior cycles by the time the employment gap crossed the 1% threshold. This may be why the Fed felt the need to end QE last year before many thought it should.
Given the subsequent further fall in the employment gap and rise in wages, it looks like policymakers were right to move on QE last year and it appears they would be right to start raising interest rates sooner rather than later.
In short, we should not fear the Fed raising rates at this time. The central bank is right on track with prior cycles. Just like the end of QE did not kill the US economic recovery, the lift-off from a 0% interest rate is unlikely to kill it, either. Nevertheless, the tightening cycle has begun in earnest and will continue until higher interest rates and further excesses in the economy do eventually lead to recession.
We believe that is more than 12 months away and could be significantly longer depending on how fast the Fed decides to drain the punch bowl.
Note: This article first appeared in the November 17, 2015 edition of “Positioning,” a publication of the Global Investment Committee, which is available by request.