At the end of last year, the Federal Reserve’s Federal Open Market Committee (FOMC) sent a clear, unanimous message about our economy’s ability to handle interest rate “normalization” by raising rates 0.25%. At that time, members’ projections indicated two to four more increases would follow in 2016. By February, clarity had shifted to uncertainty. As first quarter real GDP growth fell to under 1 percent and inflation stayed below Fed targets, dovish members publicly called for delays in projected interest rate hikes. The “Doves” prevailed in March, and the FOMC held interest rates steady, with one member dissenting the delay. The Atlanta Fed’s second quarter GDPNow forecast has rebounded to 2.8 percent, and wages are rising at a slightly faster pace. However, a May Labor Dept. report revealed unsettlingly low job creation. This weakness gave the Doves support to argue for rates to remain unchanged. In public statements, Chair Janet Yellen has signaled her desire to normalize interest rates – but not just yet.

 

Yesterday’s FOMC press release again announced no increase in interest rates; the accompanying “dot plot” projections expect weak economic factors to continue, and lower projections for interest rates into 2018.

 

June Projection	2016	2017	2018	Previous Mar.  Projection	2016	2017	2018
Change in Real GDP	2.0%	2.0%	2.0%	Change in Real GDP	2.2%	2.1%	2.0%
Unemployment Rate	4.7%	4.6%	4.6%	Unemployment Rate	4.7%	4.6%	4.5%
PCE Inflation	1.4%	1.9%	2.0%	PCE Inflation	1.2%	1.9%	2.0%
Core PCE Inflation	1.7%	1.9%	2.0%	Core PCE Inflation	1.6%	1.8%	2.0%
Fed Funds Rate	0.9%	1.6%	2.4%	Fed Funds Rate	0.9%	1.9%	3.0%

Note: Median projection; Source: Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents

Context

Real GDP increased by 2.4 percent in both 2014 and 2015, but projections for 2016 are weaker.  Households, workers and employers are adjusting to this period of sluggish growth, yielding puzzling data that reflects this changing behavior:

• Stronger job numbers through April filter through to higher retail sales in May, after a slow start in 2016. Not all higher sales came from greater consumer demand, however; gas prices rose 7.5 percent last month.
• The number of job openings in April rose to 5.788 million – matching a record high. As unemployment and workforce participation rates fall, employers cannot find workers to fill current needs.
• Wages increase, while worker productivity declines. In other words, employers are paying more and getting less. This is consistent with the worker shortage indicated by the growing “help wanted” statistic above.
• The Labor Market Conditions Index has been trending negative, and falling employment for temporary workers, a “leading indicator,” points broadly to lower employment.
• The inclusive U-6 unemployment rate remains at 9.7 percent, measuring the unemployed, discouraged job-hunters, and part-timers seeking full-time work. In addition, the number of part-time workers is rising, while the number of working-age Americans in the labor force fell slightly.
• More than half of workers age 50 or older expect to work during their retirement years – and most of those expecting to work cite “financial reasons” for working. Lower returns on nest-egg savings increase income insecurity, thereby changing retirement lifestyles.

Markets will continue to carefully parse comments from Fed officials to see how the Fed reconciles such contradictory trends and negative indicators.

Unknown Brexit Impact, Slow Growth Everywhere

The Fed continues to monitor global events, which exhibit less strength than the tepid U.S. economy and represent external risk: 

• Investors and central bankers are watching the coming “Brexit” vote on June 23, when British citizens will vote on whether to stay a member of the European Union (EU).
• European Central Bank President Draghi has called on EU governments to enact programs that counteract weak economic growth.
• China’s lukewarm economy shows little sign of improving, dragging down the growth potential of export-dependent EU and developing countries.

The Bigger Picture

Nearly seven years beyond the end of the financial crisis that threatened economies and markets, the U.S. economy plods on at a low 2 percent growth rate. New global economic projections released by the World Bank lower U.S. economic growth to 1.9 percent in 2016, and warn of recession risk along with sluggish growth in both emerging and advanced economies. While economic growth stumbles, government spending and debt increase. Ten-year projections from the Congressional Budget Office (CBO) have deficits rising every year and total debt accumulating to over $29 trillion in ten years. 

As of June 9, the Federal Reserve balance sheet reported total assets of $4.5 trillion, approximately the same level as it has been for the past two years. The Fed is the largest holder of Treasury securities in the world, owning 21 percent of outstanding debt. CBO’s projections assume that the Fed begins to reduce its portfolio at the end of 2016, but there is plenty of speculation as to how it plans to deleverage the assets it has accrued over the course of the recession and through the recovery. Chair Yellen has affirmed that there would be no reduction in portfolio assets until interest rate normalization is well under way. FOMC “Hawks” advocate more guidance on normalization. St. Louis Fed President James Bullard is calling for a “Road to Normal” that paves the way for Fed flexibility in the event of an economic downturn.