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Weekly Commentary by Dr. Scott Brown

Reasonably confident
March 2 – March 6

Fed Chair Janet Yellen signaled that officials will likely alter the forward guidance at the March 17-18 policy meeting. However, altering this guidance (the conditional commitment to keep short-term interest rates exceptionally low) is not the same as signaling that a rate hike is imminent, as Yellen made clear. She did indicate what would lead the Fed to start tightening. The Fed needs to see further improvement in the job market, it must expect even more improvement in the job market on top of that, and it has to be “reasonably confident” that inflation will move toward the 2% objective.

The Fed has relied on two extraordinary policies to provide support to the economic recovery in recent years. One is quantitative easing, the outright purchases of Treasuries and mortgage-backed securities to help push long-term interest rates lower. The other is the forward guidance. By making a conditional promise to keep short-term interest rates low for some period of time, the Fed puts downward pressure on long-term rates (long-term rates can be thought of as a series of short-term rates). The forward guidance doesn’t cost the Fed anything, making it an attractive tool to use when faced with the zero lower bound (on short-term interest rates).

Initially, the forward guidance was based on a specified time period, but some Fed officials worried that that was too vague. The Fed shifted to economic thresholds. However, as the unemployment rate approached its threshold, something had to give, and the Fed went back to a time-based directive, promising to keep rates low for “a considerable time.” That language proved useful, but as the Fed began to make plans for policy normalization, it was clear that the phrase would have to change. This created a dilemma for Fed policymakers. The financial markets could misinterpret a change in the language. Minutes from the 2014 FOMC meetings reflected a lot of anxiety among Fed officials about changing the phrase. In the mid-December policy statement, the Fed replaced the “considerable time” phrase, saying that it could “be patient” in deciding when to begin raising rates. At the same time, the Fed said that the change in language did not represent any change in the policy outlook. Thus, the Fed changed the language, but kept the sentiment, seemingly having it both ways. However, market participants soon began to speculate on when the “patient” phrase would go, believing that such a change would signal a likely rate hike at the next meeting. Yellen sidestepped that trap in her monetary policy testimony to Congress. The patient language is expected to go. However, Yellen emphasized that the change would not necessarily signal that rates would be raised within a couple of meetings. It only meant that the Fed would begin to consider the possibility of rates hikes.

The Fed is still going to rely on some forward guidance. Specifically, the Fed has indicated that short-term interest rates may remain below normal “even after employment and inflation are near levels consistent with our dual mandate.”

No surprise, the job market will play a key role in when the Fed begins to tighten. We’ve seen significant progress. However, as Yellen testified, “we’re not there yet.” Job conditions will have to improve further before the Fed considers raising rates, but it also must have sufficient momentum to improve further.

The Fed will also need to be “reasonably confident” that inflation will move back toward the 2% goal. What exactly does that mean? Fed officials are likely to differ in their views, and they’ve not done a good job in forecasting inflation in the last few years. Yellen is likely to require more substantial evidence.

Putting it all together, given the low near-term trend in inflation, most Fed officials are likely to fall into the later-rather-than sooner camp. The bigger uncertainty will be the speed of adjustment once rate hikes begin. That will be data-dependent.

Yellen’s trip to the hill, a preview…
February 23 – February 27

Fed Chair Janet Yellen will testify on monetary policy on Tuesday and Wednesday. These appearances are less traumatic for the financial markets than they used to be. The Fed releases minutes of the policy meetings on a timelier basis and the Fed chair holds press conferences after every other meeting. Hence, it’s unlikely that we’ll see Yellen signal a major change in the policy outlook. Still, the financial markets will pay attention.

The minutes of the January 27-28 policy meeting helped to clarify the outlook for monetary policy. Officials continued to prepare for policy normalization, as they worked on the technical details. The financial markets are more concerned about the timing of the lift-off – that is, when the Fed will begin to raise short-term interest rates. However, policymakers were briefed not just on possibilities for the timing, but also on the pace of rate increases. The minutes did not go into details on what the Fed staff presented or what conclusions may have been drawn, if any. Note that in her press conference in mid-December, Yellen cautioned against assuming that the Fed would raise rates at “a measured pace” (that is, 25 basis points per meeting) once tightening begins. She also emphasized that the FOMC could decide to begin raising rates at any meeting, not just the ones that have a post-meeting press conferences. So, the Fed could wait longer and raise rates more rapidly once it starts, or make larger moves on an irregular basis. Indeed, Yellen previously emphasized optimal control theory, which “calls for a later lift-off” of policy tightening.

Prior to each FOMC meeting, the Fed surveys the primary dealers, asking questions about the timing of policy firming and about the outlook for the economy and financial markets. In January, responses on the timing were all over the place, but with more than half between June and September. This is roughly consistent with the range of forecasts of the year-end federal funds rate made by senior Fed officials in December.

The FOMC minutes provided a concise picture of the Fed’s timing debate. “Several” Fed officials feared that waiting too long could lead to higher inflation. However, “many” participants (which is more than “several” in Fed lingo) worried that moving too soon could “damp the apparent solid recovery in real activity and labor market conditions.” An earlier lift-off would also leave the Fed with limited options should the economy slow (as it remains close to the zero lower bound). Many Fed officials wanted to see a pickup in wages growth or evidence that the recovery remained on solid footing, with inflation moving back toward the 2% goal “after the transitory effects of lower energy prices and other factors dissipate.”

The low inflation does not mean that the Fed won’t hike. Yellen indicated that the Fed could still raise rates as long as there is a strong expectation that inflation will move toward the 2% goal. The Fed has described the impact of lower energy prices as “transitory.” However, lower energy prices are likely to help push core inflation down in the near term.

Low inflation is also a consequence of a soft global economy. Yet, lower energy prices should help the rest of the world to eventually recover. However, the timing isn’t clear. Estimates of European growth have picked up a bit recently, due to the drop in energy prices, but there are a lot more issues in the global economic outlook besides energy.

Note that the Fed does consider the impact of a stronger dollar on growth and inflation. However, the exchange rate of the dollar is not the Fed’s responsibility (that’s the Treasury’s call). The Fed is not going to refrain from raising short-term interest rates to weaken the dollar.

Does it really matter when the Fed begins to tighten? The timing has some minor implications for longer-term Treasury yields, but it’s much more important for the middle of the curve. Forecasting the pace of policy normalization ought to be just as important as getting the start date right.

Winter of discontent or winding the spring?
February 16 – February 20

Retail sales figures disappointed in December and January. The Bloomberg/University of Michigan Consumer Sentiment Index fell back in mid-February. This news has cast some doubt about whether the drop in gasoline prices will propel consumer spending growth in the near term. However, economic data are notoriously unreliable in the winter months. The spring economic data reports should provide a better picture of the underlying strength in jobs, consumer spending, and housing.

Seasonal adjustment is often difficult, but is especially challenging in the winter months. Prior to seasonal adjustment, core retail sales (which exclude autos, building materials, and gasoline) rose 20.2% in December and fell 24.9% in January. The total for the last three months was up 4.6% y/y.

The impact of lower gasoline prices shows up with a lag. Prices fell more sharply in January, but have now risen off their lows. That’s not a surprise. Gasoline prices normally rise from December to May and then trend lower in the rest of the year.

The drop in gasoline prices has freed up about $10 billion per month to spend on other things. Note that the household sector typically pays down debt in January and February, making up for its holiday season generosity. The drop in gasoline prices should speed that adjustment and consumers will be better able to spend in March (the early Easter ought to boost spending).

Consumer sentiment spiked higher in January, but fell back somewhat in the reading for mid-February. That’s not an indication of weakness. Rather, there is a fair amount of noise in the data from month to month. The overall trend is still significantly higher. More detailed surveys have long shown a wide difference in ratings of the economy by income. Those at the top have maintained a rosy outlook for much of the economic recovery, while those at the bottom of the income scale still see conditions as troubled. Those in the middle have grown more optimistic, the most since before the recession.

Spring is the most important time of the year for the economy. It’s when most firms expand their hiring. Last year, for example, we added 4.4 million jobs between January and June (prior to seasonal adjustment) – that works out to an average of 880,000 jobs per month. Spring usually marks the seasonal peak in new home sales and construction activity. Housing has disappointed in this recovery, but anecdotal evidence points to a solid pickup in the near term. There is scope for substantial further improvement as housing activity works back toward normal conditions over the next few years.

Most investors should be aware of the noise that seasonal adjustment can generate in the economic data reports. Most of these figures are based on statistical samples, which also generates some uncertainty from month to month.

In setting monetary policy, Federal Reserve officials look at a wide range of economic data and also put a lot of emphasis on anecdotal information. That means looking beyond the noise as they attempt to judge the underlying strength.

The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.

All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.

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