The Fed’s dovish path to normalising interest rates

17th June 2016

Rick Rieder, chief investment officer of Global Fixed Income at BlackRock discusses yesterday’s Fed statement.

The Fed delivered a statement that described a more dovish path to further normalizing interest rates, as the central bank kept the door open for a possible July rate hike, but kept it barely ajar. The Fed will almost definitely not have an opportunity to move until at least the September meeting.

On labour markets, for a variety of reasons we think it’s likely that labour market growth remains slow in the back half of the year, as an already tight jobs market, weakening corporate earnings, and policy-inspired wage hikes are likely to combine to moderate growth.

Beyond its concern over slowing labour market growth and low inflation, the Fed is understandably concerned with risks from abroad, so keeping a close eye on moves in the USD and global financial conditions, such as those in China, will be important for understanding the timing of any Fed move, as will the near-term path of hiring after May’s weak payroll report.

 Slowing Domestic Jobs Growth, combined with concerns from abroad, complicate the Fed’s own job.

The announcement and press conference put forward by the Federal Reserve’s Federal Open Market Committee (FOMC) generally represents a continuation of its “wait-and-see” approach, which nevertheless also seems calibrated to continue to try to leave the door open to some degree of interest rate policy normalization this year. Still, the pace of that change has been profoundly altered since the December 2015 meeting, both as a result of domestic considerations as well as international concerns. Thus, as we have argued previously, accurately judging the policy path for the Fed will require keeping one eye on domestic economic fault lines (jobs growth, inflation expectations, and corporate profits, for example) and the other eye on conditions abroad, and particularly in China, which continues to stand as the most important lever of global economic growth.

The extraordinary weakness displayed in May’s employment report, alongside the disappointing revisions to the March and April payroll prints (even after adjusting for the Verizon strike and weather-related factors) underscored our view that jobs growth had to moderate this year. Indeed, with the large-scale employment gains witnessed in recent years, we knew a continuation of that pace would be very difficult to sustain. Further, we have grown increasingly concerned over the rolling over of corporate profits, as payrolls tend to track corporate profits quite closely (with a six-month lag), so we continue to expect to see weaker jobs numbers as the year progresses.

Finally, we’re concerned that one of the strongest sources of job growth in recent years, the leisure and hospitality sectors, could now face a significant headwind. That headwind takes the form of higher wages, both due to a tight market for labor and due to some meaningful increases in minimum wage rates in several states. When wage costs are increased through policy rather than via market mechanisms, revenues and profits can take a hit unless businesses can exhibit pricing power to correspondingly increase what they charge end customers to offset their own labor cost increases. The net result could well be lower levels of hiring in this important area of the economy. Still, how would slower labor market growth influence the Fed’s reaction function?

Given that strong labor markets have been one of the hallmarks of the past few years of expansion, a slowing in this area would certainly make raising rates more difficult for the Fed. Ultimately, we do believe interest rates should be normalized at a measured pace, given that it’s clear to us that the economic effectiveness of low rates in stimulating economic growth has been significantly diminished in recent years. At the same time the externalities of the policy have been on full display. Still, much more normalization this year may be difficult for the central bank to accomplish, particularly should jobs growth continue to slow, inflation expectations and realized inflation remain moderate, and both domestic and international political risks continue to roil markets. Unless we see a significant improvement in economic data, and stability in global financial markets, we are likely to see only one or at most two rate hikes this year, and while July is still a possibility, the year’s last third is a more likely time for any policy move.

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