From: Gregory S. MacKay, Economist
The minutes of the March FOMC meeting gave us two clear messages: 1.) The FOMC (committee) continues to believe in slow and gradual increases in rate hikes this year and 2.) There could very well be some movement toward shrinking the Fed’s balance sheet by year end 2017.
On the first message…… the FOMC remains convinced that the “neutral federal funds rate” (rate that is neither expansionary nor contractionary when the economy is operating at or near its potential) appears low by historical standards, suggesting the slow gradual approach to rate increases will continue. Data received since the FOMC meeting supports the gradual view. While factory orders increased 1% in February, most of the gain was in non-defense aircraft. There was some strengthening in some durable goods sectors, but autos remained weak. Economic growth as measured by the ISM Indices (Manufacturing and Non-Manufacturing) both continued to show increases in most business categories, but at a slower pace. So, business investment hasn’t shown any signs of growing strength.
The inflation picture has also changed a bit since the FOMC meeting. The March Producer Price Index (PPI) dropped .1%, the first drop in over 6 months. “Core” PPI was flat. Year-over-year PPI rose 2.3%, and the core was up 1.6%. Oil prices are stabilizing and taking much of the steam out of wholesale goods and services pricing. Similar data for March came from the Consumer Price Index (CPI). The index for all items fell .3% from February, and the core (no food or energy) dropped .1%. The 12 month all item index was up 2.4%, but down from February’s +2.7%. The core index rose 2% over the last twelve months, the smallest increase since late 2015. Retail energy prices have fallen two months in a row, as have vehicle prices. There has also been a slowing in the price increases for service sector components.
Similar data have been forthcoming from consumer measures. While consumer sentiment has remained high, this has been a lack of follow through in consumer spending. Credit card usage was negative in January and had a very small increase in February. Auto and student loans remain somewhat below levels reached in the last several years. The latest payroll figures were also less than hoped for. Job gains in March were a paltry 98,000, bringing the three month average down to 178,000 per month. (The 2014 average was 250,000 new jobs each month). Perhaps March was a “one of” due to the weather, but we need some sizable gains to offset March. Better news on the unemployment rate, which dropped to 4.5% (best since mid-2007). The average hourly earnings rose .2% in March, and were up 2.7% over the past year. With inflation factored in, that’s less than a 1% gain, also explaining the caution of consumers. The slow growth of GDP was also enhanced by the latest retail sales figures. Total retail sales in March fell .2%, after February’s .3% decline from January. Motor vehicles continue to drag, down 1.2% in March and down 1.5% in February. Building material, gasoline and restaurants also fell. However, year-over-year retail sales are better than 2016, but not sufficiently enough to suggest any real economic strength in the first quarter of 2017. It’s hard to suggest a June interest rate increase with slow business and consumer spending, and waning inflation.
The second message was somewhat intriguing. The size of the Federal Reserve Bank balance sheet rose from less than $1 Trillion in 2007 to the current level of $4.5 Trillion due to its programs of asset purchases that pumped money into banks. While ‘fiscal policy” (government spending and policies) created some cushion during the Great Recession, it was the Federal Reserve Bank that pumped trillions of dollars into the economy by buying U.S. Treasury bonds and Mortgage Backed Securities (pools of mortgages that most investors weren’t buying). Thus, the Fed now owns $2.5 Trillion of U.S. Treasury debt and another $1.8 Trillion of mortgages of people like you and me. Historically, moving the federal funds rate up and down has been the primary method of controlling growth and inflation. However, the Great Recession has given rise to a new tool, the advancement or contraction of the Fed’s balance sheet.
Discussion at the March FOMC meeting seemed to indicate that there was broad support for shrinking the balance sheet later in 2017. That means allowing the bonds the Fed owns to mature and not be reinvested. In order for mortgages to continue to be made, and the government to borrow money to operate, other buyers (banks, foreign countries, investors) would have to step up and buy the bonds being issued. This movement will draw money out of these investor products rather than the Fed, and probably raise interest rates. Thus the Fed has the ability to slow growth and inflation with this tool in a size never before experienced. This would take pressure off the federal funds rate, while increasing longer term bond rates, perhaps moving interest rates back to a more normal pattern. While it’s much too early to tell when the FOMC will act on this, the March meeting was clear that investors would be well aware of the Fed’s intentions before they acted…… that’s kind of like showing your poker hand to the rest of the table…….. so as to minimize any possible short term market disruptions.
So we’ll keep an eye on incoming data to judge the need for more FOMC intervention, and we’ll watch for some movement in the tools the Fed uses to implement the changes….. it’s all data dependent, with a new twist.
Markets are closed today for Easter and Passover observances. Stocks gave up a little of their gains this week as corporate earnings for the first quarter aren’t yet available.
Bond yields fell about 20 basis points in the past two weeks.