3 Data clues for a data-dependent FedContributor David Lebovitz
BASED ON RECENT DATA, THE FED IS STILL ON TRACK TO RAISE RATES IN SEPTEMBER
Last week was a busy week for investors, as the Federal Reserve (Fed) held its July meeting and data on capital spending, manufacturing, confidence, housing, growth and wages were all released. However, with a weak first quarter still fresh in the minds of investors, the GDP report and minutes from the Fed stole the show. Despite a disappointing first quarter for the U.S. economy, things seem to have rebounded into the second half of the year. Based on what we can glean from the Fed’s most recent statement, a September rate hike still appears to be in the cards. For clues to the Fed’s potential path, we point to three sources:
1. Fed’s July statement
Although there was no press conference, the statement released following the Fed’s July meeting was broadly in line with investor expectations. But a few tweaks in the statement’s language did offer some clues about how the Federal Open Market Committee’s (FOMC) thinking has changed over the past month. Based on the remarks of various Fed governors, as well the July statement, it is clear that the FOMC has been looking past the weak first quarter for the U.S. economy, and focused instead on the improvements observed since then, particularly in housing. The most important tweak to the language was the upgrade of the characterization of the labor market. The FOMC has seen “solid job gains” and “diminished” underutilization of labor resources since the beginning of the year, which signals that the economy is coming closer to using up its available labor. Given this meeting’s statement, we believe the Fed will hike rates in September.
2. Early estimates of 2Q GDP
One key data point released last week was the first estimate of second quarter GDP, which contained revisions to the data back to 2012. Second quarter real GDP growth came in at an annual rate of 2.3%, below the consensus of 2.9%. However, growth for first quarter GDP was revised from -0.2% to +0.6%, which suggests that the Fed took the correct approach in looking through the weaker data as they debated policy at the July meeting. If the economy expands at an annual rate of 2.5% in the second half of 2015, real GDP growth for the full year we will come in at 2.1%, slightly above the Fed’s forecast of 1.9%.
However, there were some details in the GDP report which suggest that economic growth may face some headwinds in the second half of the year. Real inventory accumulation of $110 billion in in the second quarter, relative to an average of just $29 billion over the past decade, suggests that growth will need to come from other areas of the economy going forward. Finally, revisions since 2012 show that this recovery has been even slower than previously thought. After six full years of recovery, the economy has managed just 2.1% real GDP growth per year, compared to the 2.2% growth previously reported through first quarter.
3. Data releases between now and then
We know, of course, that any decision that the Fed makes will be data dependent. Therefore, the data releases between now and the next meeting on September 17 will be pivotal in the Fed’s decision. Although the Employment Cost Index (ECI) for the second quarter, released last Friday, showed that wages stagnated in 2Q, the various measures of wages that are available have been sending mixed signals regarding the presence of wage inflation. The weaker ECI data does not rule out a September hike, but it will be important to watch the wage data in the August and September employment reports to see if this weakness in wages may be indicative of a broader trend.
Now in its seventh year of the expansion, the U.S. economy continues to grow at a moderate, but steady pace. Despite some disappointing first quarter economic data, recent releases have shown that the economy, and most importantly, the labor market continue to heal. Barring a significant deterioration in the data, we expect the Fed will begin raising rates for the first time since 2006 in September. However, more important than the timing of the first rate hike is the pace of subsequent tightening.
With the Fed still on track to raise rates in September, investors should have a framework for investing in fixed income against a backdrop of gradually rising rates.
Investments in bonds and other debt securities will change in value based on changes in interest rates. If rates rise, the value of these investments generally drops.