June or September liftoff, does it really matter?

Even as the Standard & Poor’s 500 and Nasdaq continue to trade near multiyear highs, the threat of an imminent rate increase continues to loom over markets.  

Rates have been truncated near zero for most of the last six years, so any upward movement will signal a new era in monetary policy reinstating the Fed funds rates as a major policy tool.   

There are many arguments in support of a move. The million-dollar question is whether policymakers will flip the switch at their June or September Federal Open Market Committee (FOMC) meeting. But is the timing of the first rate hike of such great economic significance? Or is it the path of future rates that will most impact economic activity? 

Those in favor of a rate hike in June cite significant broad-based improvements in the labor market. In March, the U.S. Labor Department reported job openings at a 14-year high with a muted pace of dismissal.  

Further, the steep fall in the unemployment rate to 5.5 percent is teetering on the range the FOMC deems consistent with the nonaccelerating inflation rate of unemployment (NAIRU), the specific level of unemployment that does not cause inflation to increase. T 

hese data points are certainly impressive when we consider the harsh weather experienced in the U.S. Midwest and Northeast, and the recent slowdown in the economy which tempered demand for goods and services during the first quarter. 

The gain in core inflation prices to 1.8 percent in April is certainly trending closer to the Fed’s 2 percent medium-term target. Given the restraints of a strong dollar on import prices, coupled with lower energy prices over the last nine months, a rate this close to the Fed’s target could warrant the much-anticipated move. Should energy prices revert to their mean along with any weakness in the dollar, a run in inflation beyond the Fed’s 2 percent inflation rate is easily conceivable.  

Supporters of a September or later rate hike equally pose some fundamentally striking arguments. During the quarter, the Institute for Supply Management manufacturing index fell to 51.5; U.S. export contracts and factories experienced the slowest pace of expansion since 2013. With the fall-off in commodity prices, energy producers halted investment spending, while order backlogs and new orders continue to fall, quelling any positive momentum for manufacturing in the short term.  

Even more impactful for a service-driven economy, the consumer is still feeling the pinch. Housing, a major indicator of U.S. household wealth, initial housing starts fell below forecast as applications for building permits decline. And while the headline numbers for jobs are better than expected, the pace of hiring has slowed. with only 126,000 jobs added in March, the lowest month over month increase in almost two years.  

Predictably, the uneven employment and housing data preceded a decline in retail spending as lower energy prices did very little to offset the slowing recovery and weak growth suggested by the Index of Leading Indicators.  

With strong support on both sides of the coin for a rate move in June or September, policymakers are grappling with a decision for which there is no clear direction. Fearing a disruption to the growth trajectory, there is much uncertainty surrounding the Fed’s actions in the face of changing labor market dynamics and higher inflation expectation from transitory factors in falling oil prices and a strong U.S. dollar. Given the Fed’s dual policy mandate of full employment and price stability, an unemployment rate close to the NAIRU, even as inflationary pressures rise, would almost certainly suggest a move is imminent. 

Perhaps the most significant factor impacting the Fed’s decision is the unequal risks inherent in moving too early versus moving too late. A move too early, similar to the European Central Bank and Sweden’s Riksbank in 2010, could cause economic growth to falter and inflation reversing course. Faced with this scenario, a return to zero-interest rate policy would be the expected course of action given an already inflated balance sheet and limited monetary policy arsenal.  

Alternatively, delaying a hike could result in inflation quickly moving beyond the 2 percent medium-term target. Such a move would force the Fed to increase the pace of its hikes in an attempt to control prices. With greater flexibility to control an inflated economy, the risks of a later move appear to be the safest course in steering the world’s largest economy back to economic growth.  

 

Disclaimer: The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. The bank accepts no liability for errors or actions taken on the basis of this information.
Statistics and data source: Bloomberg LP., Capital Economics  

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Janet Yellen, chair of the U.S. Federal Reserve, is seen on a television monitor listening to a question during a news conference following a Federal Open Market Committee (FOMC) meeting in Washington on March 18. – Photo: Bloomberg News.
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