For the first time since Q2 2006, the Federal Reserve is finally moving toward raising interest rates. As always, the big question for traders though is when: financial media outlets and recent comments from Federal Reserve officials suggest that the central bank may begin increasing interest rates at its September meeting, whereas futures traders still marginally favor the December 2015 – March 2016 timeframe.
To help put the Fed’s historic decision into context, we must look at it through the eyes of the central bank’s famous “dual mandate” to promote maximum employment and stable prices. At first glance, the central bank is knocking the ball out of the park on the first objective. The unemployment rate has dipped to just 5.3% as of the July employment report, which showed another solid 200k+ jobs were created. This represents the lowest unemployment reading since April 2008, when the economy was firing on all cylinders, and is in line with many Federal Reserve officials’ estimates of “full employment” (accounting for unavoidable “frictional” unemployment, when an in-demand employee temporary transitions between jobs). In fact, the US economy has added jobs for 58 consecutive months, the longest streak since WWII.
However, the Federal Reserve continues to fall short on the “stable prices” half of its dual mandate (interpreted as 2% growth in the Core Personal Consumption Expenditures price index). As of the June Bureau of Economic Analysis (BEA) report, the Core PCE inflation rate was just 1.29% year-over-year. More worrying, the trend in the price index remains clearly lower over the last three years since the Core PCE rate briefly hit 2% back in early 2012. For what it’s worth, Federal Reserve officials have recently noted that the inflation rate does not need to be at the 2% target to start raising rates – after all, monetary policy will still remain accommodative even with the Fed Funds rate at 1% or 2% – but the consistent lack of upward pressure in Core PCE, the more widely-followed Consumer Price Index (CPI), and average hourly earnings is concerning for the central bank.
No matter how you look at it, the Federal Reserve will face a difficult decision at its September meeting. Indeed, it’s likely that some of the FOMC members do not yet know which way they will they vote yet; to that end, the economic data over the next several weeks will be absolutely critical. Specifically, the July and August Consumer Price Index reports (scheduled for release August 19 and September 16, respectively), as well as the August Non-Farm Payroll report (September 4) will be closely watched. If core inflation starts to tick up toward a 2% year-over-year growth rate and payrolls remain above 200k, it could tip the scales toward a September lift off, but if the US economy fails to meet those goals, the majority of FOMC voters may opt to hold off until December or later before raising rates.
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