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Weekly Commentary by Dr. Scott Brown

The Dots
September 22 – September 26

As was widely anticipated, Federal Reserve policymakers reduced the monthly pace of asset purchases by another $10 billion and kept the “considerable time” language. Fed policymakers revised slightly their forecasts of growth, unemployment, and inflation. However, the really interesting item in the Fed’s Summary of Economic Projections was the dot plot, the projections of the appropriate year-end level of the federal funds rate for each of the next few years. There is a huge range of uncertainty among Fed officials.

In announcing its plans to normalize policy, the Federal Open Market Committee indicated that it will announce a range for the federal funds rate. The dot plots show the middle point of each Fed official’s projection of the appropriate year-end range. The five Fed governors and 12 district bank presidents differ widely in their expectations for the federal funds rate at the end of 2015 (and implicitly, in their expectations of when the Fed will begin raising short-term rates). Projections of the federal funds rate at the end of 2016 are even more widely dispersed.

The 2015 projections suggest that there is not clear consensus among Fed officials regarding when the first rate hike will come. Implicitly, most appear to be almost evenly spread between March and September next year. In the Fed’s next update of these projections (December 17), we should see the 2015 dots coalesce around a specific level, signifying a developing consensus for when the first rate hike will occur.

Why such a large range in the federal funds rate projections? Fed officials differ in their expectations for growth and inflation, but mostly in their perceptions of the amount of slack in the economy, especially in the job market. The unemployment rate has fallen significantly over the last few years, but the figure has been distorted by a drop in labor force participation. The baby-boomers began to reach retirement age just as the Great Recession got underway, making it difficult to isolate the demographic impact. Moreover, the unemployment rate does not reflect underemployment, the number of individuals who are involuntarily working part time but would prefer full-time employment, and those who are not searching for a job but would if the labor market were stronger.

There are many labor market indicators. Some suggest stronger conditions than others. As Fed Chair Yellen noted in her Jackson Hole speech, the Kansas City Fed’s Labor Market Conditions Index, a composite of 24 job market gauges, provides a convenient summary. The trend in the LMCI through August is consistent with the view that the slack in the labor market is being taken up gradually, but that we still have a long way to go.

A weak trend in inflation-adjusted earnings is another sign of slack in the job market. Real average hourly earnings rose just 0.4% over the 12 months ending in August. That’s not a lot of firepower for consumer spending growth. Thanks to job growth, you can still get growth in aggregate income, and in turn aggregate spending, but the lack of wage growth is a limiting factor for consumer spending growth (which accounts for 70% of Gross Domestic Product). Wage growth should pick up as the labor market tightens, but recent reports suggest little upward pressure on wages for the near term.

Fed Chair Yellen emphasized that rates could be raised “sooner and more rapidly” if the economy proves to be stronger than expected. Conversely, if economic performance disappoints, “increases in the federal funds rate are likely to take place later and to be more gradual.” While there is a wide range in the projections of Fed officials, there is a high degree of uncertainty in the individual forecasts themselves. The decision to begin raising rates will be driven by the economic outlook, estimates of the amount of slack in the job markets, and assessments of how rapidly slack is being taken up. The recent economic data suggest that the Fed will be in no hurry to tighten.


Mind Your Language!
September 15 – September 19

The Federal Open Market Committee is widely expected to take another trip to Taper Town on Wednesday, reducing the monthly pace of asset purchases by another $10 billion, one step closer to ending the program in late October. The more interesting issue is whether we’ll see any change in the Fed’s forward guidance on short-term interest rates – specifically, whether the FOMC will jettison the “considerable time” language. Probably not, but there will be plenty of other points of interest contained in Fed officials’ revised economic projections and in Janet Yellen’s post-meeting press conference.

Two years ago, the FOMC began its current Large-Scale Asset Purchase program (LSAP, but more commonly referred to as “QE3”). As it did, the FOMC said it expected that “a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.” In its forward guidance on short-term interest rates, the FOMC indicated that “exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.” That time frame was pushed out from the previous policy statement (“at least through late 2014”). At the December 2012 meeting, the FOMC shifted to economic thresholds for its forward guidance; short-term rates would remain exceptionally low as long as the unemployment rate was above 6.5%, the one-year-ahead inflation outlook was less than 2.5%, and inflation expectations remained “well anchored.” As the unemployment rate drifted toward 6.5%, the Fed had to rethink this guidance. At the March 19 policy meeting this year, the FOMC indicated that “it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.” That language was carried forward in the policy statements in April, June, and July. Some Fed observers think it’s time for a change.

The “considerable time” phrase echoes similar language used ahead of the previous tightening cycle in 2003, when the FOMC indicated that it expected to keep short-term rates low (the federal funds target was 1% at the time) for “a considerable period.” That phrase was included in four policy statements in late 2003, but did not appear in the January 2004 statement. The Fed began raising the federal funds rate target in June (at which point, policymakers indicated that rate hikes were expected to come “at a measured pace”).

At this week’s policy meeting, Fed officials will update their projections of growth, unemployment, and inflation. These forecasts also include expectations of the federal funds target rate at the end of the next few years. This week, the Fed’s Summary of Economic Projections (SEP) will extend these forecasts to 2017. In her March 19 press conference, Chair Yellen cautioned against reading too much into the dots (“I would simply warn you that these dots are going to move up and down over time a little bit this way or that”). That’s true, but there is important information in those projections.

In June, as in previous projections, the federal funds rate forecasts of the Fed governors and district bank presidents were all over the map. All but one Fed official expected that the federal funds rate target would not be raised this year. All but three expected rates to begin rising sometime in 2015. However, there was a wide range for where the target was expected to be at the end of 2015 and 2016. If one assumes that rate hikes will be made in “measured steps” of 25 basis points, the individual year-end forecasts for 2015 would imply an equally wide range for the expected date of the first rate hike (three for July, three for September, one each for March, April, June, October, and December, with three for 2016). One thing to watch for in the September SEP: will the individual federal funds rate forecasts bunch up a little more around specific year-end targets (and implicitly, dates for the first rate hike)?

Some Fed officials have suggested that it’s time to jettison the “considerable time” language and tie the rise in rates back to the economic data. Fat chance. Inflation hawks gotta squawk, but the inflationistas are a small minority at the Fed. Still, it’s not unusual for the majority to tweak the language of the policy statement slightly to put the hawks a little more at ease.

Fed officials know that short-term interest rates will have to be raised at some point, but they don’t want financial market participants to misinterpret their intentions. The bottom line remains: monetary policy in 2015 will depend on the evolution of the economy in the second half of 2014.


As The World Turns ...
September 8 – September 12

U.S. economic data were mixed last week, but there was nothing in the August Employment Report to suggest that growth is slowing down. A surprise move from the European Central Bank pushed the euro lower, but there appears to be a lot more that the ECB can do. Attention will soon turn to the Fed’s September 16-17 policy meeting, where another $10 billion taper in the monthly pace of asset purchases is factored in. The Scottish Independence Referendum (September 18) has generated more suspense than was anticipated.

Nonfarm payrolls rose less than expected in the initial estimate for August, restrained partly by two factors. Seasonal auto plant shutdowns were much more moderate this year – fewer auto layoffs in July, less of a rebound in August (which shows up as a seasonally adjusted gain in July and a seasonally adjusted decline in August). Labor strife at a New England grocery store chain contributed to a 17,000 drop in employment at food & beverage stores. Together, these factors may have reduced August payrolls by about 25,000, explaining some (but not all) of the shortfall in the headline payroll figure.

The unemployment rate edged down to 6.1%, but the decline was concentrated among teenagers (19.6%, vs. July’s 20.2%) and young adults (10.6%, vs. July’s 11.3%). The unemployment rate edged higher for the prime-aged cohort (5.3%, vs. 5.2%) and older workers (4.6%, vs. 4.5%). One month does not make a trend and there’s a fair amount of statistical noise in these data. The employment/population ratio for the prime-aged cohort has been trending higher, but the level suggests that there is still considerable slack in the labor market.

Average hourly earnings rose 2.1% y/y, but this is barely keeping pace with inflation. Lackluster wage growth is a restraining factor for consumer spending growth, preventing the recovery from building a larger head of steam.

While the U.S. economy is improving, the euro area’s economy is looking feeble. Real GDP rose 0.7% in four quarters ending 2Q14 and momentum has faded. Inflation in the euro area was 0.3% over the 12 months ending in July. Deflation, a decline in the general price level, is to be feared, but not to the same degree it was a decade or more ago. Japan’s experience suggests that deflation need not be a death spiral (where frozen consumer spending and business investment lead to even weaker growth and even lower prices). Still, very low inflation can create significant problems for an economy.

Fiscal policy in the euro area, as with the U.S. last year, is going in the wrong direction. Reducing the size of the government may indeed be a worthwhile goal in a healthy economy, but in a gradual recovery, it is simply bad news (“contractionary” policies are contractionary!). None of that appears likely to change anytime soon. French President François Hollande recently sacked his finance minister after he opposed austerity.

That leaves the European Central Bank as the only game in town, but there are limits to what a central bank can achieve when faced with the zero lower bound on interest rates. The ECB’s asset-purchase program may help, but it’s unlikely to be enough. Draghi indicated that asset-backed securities would be accepted as collateral, not purchased outright (hence, technically not “quantitative easing”). However, in his press conference, Draghi indicated that the ECB’s Governing Council did discuss QE and officials were split in both directions (some wanting to do more, some wanting to do less).

Scotland will vote on independence on September 18. The “no” vote is expected to win, but polls currently suggest that it’s a lot closer than was anticipated a month or two ago. Scottish independence would generate some economic dislocations in the short term. Hence, financial market participants should pay attention – that is, once they’re done listening to Yellen.


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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