Data Dependency and Murky Waters for the Fed

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Economic data points to September 2015 as a good time for the US Federal Reserve to increase interest rates.

Dominating the news headlines has been the US Federal Reserve’s (Fed) timeline for raising interest rates from the current range of 0% and 0.25%. The Federal Open Market Committee (FOMC), a branch of the Federal Reserve that is responsible for monetary policy, indicated in a March 18 statement that it would no longer be “patient.” This does not mean there will be any degree of impatience at this delicate time, but it does provide the institution with more room regarding the best moment to increase interest rates.

After the US economy added 295,000 jobs in February, which reduced the unemployment rate to 5.5%, some analysts and economists were entertaining the idea that June would the month of interest rate hikes. Whatever the case, the Fed has to keep in line with its dual mandate, which involves a 2% inflation rate while ensuring maximum employment. As for the latter, this is when the economy has employed as many people as possible, keeping a stable rate of inflation. Even though the Fed revised down the country’s projected gross domestic product (GDP) growth by 0.3% (2.3 to 2.7%) for 2015, it is likely that interest rate hikes will happen this year. However, with a number of complications taking place, it seems that the best time to increase rates might not be in June after all.

Strengthening Dollar

The US dollar has seen a stunning rise in comparison to other currencies as the global economy still teeters to some form of sustainable recovery. Japan and the eurozone are slowly emerging from sluggish growth, while China aims to transition its economy toward domestic consumption. Since oil prices are denominated in dollars, the fall in Brent and WTI crude has led to an increase in the purchasing power of the US dollar. Finally, interest rate cuts from emerging markets to the eurozone could lead to a depreciation of currencies as investors look elsewhere for higher yields.

As the dollar gets stronger, US exports will be dearer while imports into America will be cheaper. This will put pressure on US competitiveness and may increase the trade deficit. Sam Bullard and Sarah House, economists at Wells Fargo, note that “excluding fuel, import prices fell 0.3 percent” in February. This drop in import prices may contribute to lower inflation, which rose 1.3% in January from the previous year. That was the 33rd month that the Fed did not hit the 2% inflation mark.

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© Shutterstock

The stronger dollar will also affect some businesses and could lead to a reduction in employment within these sectors. However, research from Wells Fargo economists Jan Bryson, Tim Quinlan and Sarah House highlight that even though there was a “20 percent erosion in the price competitiveness of U.S. goods and services between early 1995 and late 2000, real exports of U.S. goods and services rose more than 40 percent during that period.” The analysts argue that global economic growth contributes more toward US export-led growth, which could quell fears on the adverse effects of the stronger US dollar.

The result of cuts in interest rates from other countries to spur growth may lead to a depreciation of their respective currencies. The US dollar will be stronger in comparison, and it will complicate matters for Fed Chairwoman Janet Yellen. But it should not be the only thing that she should be mindful about.

Slow Start to the Year

The past couple of months have been difficult for people all over the United States. The freezing weather encapsulated the American northeast and subdued consumer buying plans. Retail sales fell by 0.6% in February, which was the third month in a row for declines in the measure. Along with that sluggish statistic, there was a 2.5% decline in motor vehicles and parts from the previous month, which portrayed the adverse impact of weather on car-buying moods in the US. While the Fed will pay attention to a gamut of indicators, the central bank will look to see that these declines are a result of the weather.

In addition, the Los Angeles port strikes, along with lower oil prices, have likely affected business investment and sentiment, especially in the energy sector. While the reduction in capital investment from energy firms should not disrupt US growth in a massive way, it is still worth noting that there could be cutbacks within the energy sector. Even though this a difficult period for the energy sector, the FOMC March policy statement mentions that “business fixed investment is advancing.” Nonetheless, Wells Fargo economists revised down its US first quarter GDP growth forecast to 1.1% because of the events at the start of the year.

Thus, the economic weakness in some sectors should be transitory, but only time will tell about the spillover effects. Rather than increase interest rates in the June or July meetings, Atlanta Federal Reserve President Dennis Lockhart states that the economy should show “accumulated progress.” Hence, a wait till September provides such a timeline to see progress.

Poor Inflation Readings

As aforementioned, the Fed has struggled to get the personal consumption expenditures (PCE) price index — the preferred inflation gauge for the Fed — to 2%. The Fed indicates in its policy statement that “inflation has declined further below the Committee’s longer-run objective, largely reflecting declines in energy prices.” Again, the importance of stable inflation at 2% cannot be overestimated as the economy will face immense problems at the hands of deflation.

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© Shutterstock

An increase in interest rates may lead to a slowdown in the economy and inflationary expectations. Since people may spend less with higher interest rates, there will be a slowdown in consumption-fueled inflation. The Fed must ensure that the economy can carry itself to achieve its goals of 2% inflation in the medium-term. If the Fed misinterprets the strength of the US economy, then inflation could fall back down, requiring low interest rates that will renew fears of a bubble in the economy.

Looking at the data, core PCE inflation, which is a measure of inflation without taking into consideration food and energy prices, rose at 1.31% in January from a year ago. After taking into consideration food and energy prices, the PCE index rose only 0.2% in January from a year prior. This is expected because of the fall in oil prices and its effect on other commodities as well. FOMC projections only see core PCE inflation at 1.3 to 1.4% this year, reaching 2% in 2017. With stubborn inflation readings, there needs to be a little more time to see whether inflation will remain at such levels for the near future.

With low gasoline prices and better weather conditions, people would spend their extra money. However, consumers are saving the extra cash from low gasoline prices, according to a Wells Fargo/Gallup survey. From the people questioned, 37% indicated that the money will be used to pay bills, while only 25% will go for “additional purchases.” If oil prices sustain their current lows and people are in a strong enough financial position, there could be a boost in consumption toward the end of 2015. The result could demand-pull inflation, but it could be slightly offset by the job losses in the energy sector. Nonetheless, the Fed should give itself that extra time to see if inflation is likely to rise to 2% in the medium-term.

Wage Growth

Struggling wage growth is a problem in the United States. If hourly wages rise by a higher percentage, this could spur inflation readings along with consumption. With consumption making up a strong percentage of the US economy, a break in the wage slump will lead to an improvement in the economy. Yet average hourly earnings for all private-sector production have consistently stayed at around 2% since the recession ended.

Yellen would like to see an increase in the wage growth, but it may not be a precondition for increasing interest rates. With wage growth not breaching the slump for years, more time may be required to see if wage inflation can increase. Again, September provides the room for the Fed to be data dependent as the economy may add enough jobs and see a rise in wages.

Uncertainty From Abroad

From the eurozone to Japan, there seems to be a lot of uncertainty in global markets. While the Japanese government upgraded its view on its economy with an improvement in consumer sentiment, a virtuous cycle is “far from assured.” Wages are stagnant, and saving rates are falling because of the growing cash reserves for businesses, which stand at around 40% of the stock market value.

Even the eurozone remains a mixed bag as Greece tries to present economic reforms and fight austerity measures. The country has promised to pay its creditors, but it has to meet economic reforms to obtain access to the cash it needs. The European Central Bank’s policies to purchase sovereign bonds have depreciated the euro, which may result in a favorable environment to spur economic growth. Yet time will only tell if this will lead to a sustainable improvement.

While Yellen must focus her efforts on the US economy, she knows that shocks in other parts of the world may be felt in America. The summer may show whether the eurozone’s €60 billion a month purchasing of sovereign debt will lead to a significant recovery, and whether Abenomics will show sustained positive inflation and economic growth in Japan.

Time to be Data Dependent

Recently, Federal Reserve Vice Chair Stanley Fischer spoke about US monetary policy in New York, and he mentioned that increases in monetary policy should take place this year. He stated that “liftoff [or increases in interest rates] should occur when the expected return from raising the interest rate outweighs the expected costs of doing so.” Indeed, the Fed will consider a swath of data to ensure the US economy is on the right course for the future.

A subjective tool is the Fed’s dot plot, which shows what each FOMC policymaker believes interest rates should be at the end of the calendar year. While it would be difficult to forecast anything, it is interesting to see that most policymakers expect interest rates to increase in 2015.

The Fed must be careful not to increase rates too fast, so it does not shock the economy back into a recession. It is a tedious time for the Fed, and its data dependent role is a good one. The economy needs more time to strengthen. Patience is a virtue and runaway inflation does not seem to be too much of a concern at the moment. It is time to wait and increase rates later rather than sooner.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

Photo Credit: Isak55 / Triff / Orhan Cam / Shutterstock.com


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