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A Mosaic Approach to Raising the Fed Funds Rate 

Kristina Hooper 

The Upshot 

6/23/2014 

The Federal Reserve is using a wide swath of economic data and anecdotal evidence to determine when to raise its benchmark interest rate. While prudent, it may stir up anxiety and volatility for equity investors, writes Kristina Hooper.
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Kristina Hooper is the US investment strategist and head of US Capital Markets Research & Strategy for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.

Mosaics are beautiful, but they’re hard to put together.

One of the most momentous developments in monetary policy this year has been the Fed’s departure from using a soft target of 6.5% unemployment as the trigger for an increase in the fed funds rate. Instead, as the Fed explained in its March FOMC meeting announcement, it’s going to assess the health of the economy using a wide range of information including labor market data, inflation pressures and expectations and other financial developments.

Yes, rather than focusing on just one metric such as the unemployment rate, the Fed will be looking holistically at the economy, reviewing a mosaic of data to determine whether the economy needs further accommodation. While this seems sensible given that one metric may not give an accurate indication of the state of the economy, it adds a level of uncertainty for investors. The challenge is trying to understand when—and how quickly—the Fed will begin raising short-term interest rates, and what that means for stocks.

Tapering, Then Tightening

Despite the Fed’s insistence that tapering is not a pre-set course, it seems to be on that exact path. The market recognizes that it will take a significant change to alter this timeline. As a result, we’re seeing investors trying to gauge the timing of the first rate hike and position themselves accordingly.

While the economy appears to be growing faster in the second quarter than the first quarter, there are a few factors that may hasten or postpone the Fed’s decision to raise its target rate. The biggest factor that can accelerate the start of tightening is inflation. And we’ve seen a significant increase in inflation recently. CPI rose 0.4% in May—doubling expectations—on the heels of a 0.3% increase in April. Inflation is now running at 2.1% year over year, which is above the Fed’s “soft” target for inflation.

Upshot Chart

Why is the Fed resisting raising short-term rates for now? First, the Fed views the personal consumption expenditures deflator, not the consumer price index, as its primary measure of inflation. And the PCE deflator is running much lower than the CPI. Second, the FOMC needs to see inflation remain higher for a sustained period of time, as the recent move could be a temporary spike. It must be significant enough to change inflation expectations.

… we haven’t yet seen the significant wage inflation that [Janet Yellen] believes is necessary to produce a sustained rise in inflation.”
But most importantly, Fed Chair Janet Yellen doesn’t believe inflation is an issue. Why? Because we haven’t yet seen the significant wage inflation that she believes is necessary to produce a sustained rise in inflation. However, if inflation continues to rise, and remains elevated, then the Fed will have less and less flexibility. At some point, the Fed will be forced to take action.

Home Repairs

Alternatively, housing weakness could result in the Fed keeping monetary policy looser for longer. Last week, May housing starts and the latest weekly mortgage applications came in lower than expected. And while the housing market index indicated solid gains for June, traffic was anemic—a sign that there isn’t widespread participation in the housing market. In fact, housing has really been in the doldrums since last summer, when mortgage rates began to rise in the wake of Ben Bernanke’s “taper talk.” However, we have seen some improvement since the harsh winter ended.

Last month, Yellen explained that even though the economy is showing some signs of improvement, there are concerns over the housing market: “One cautionary note, though, is that readings on housing activity—a sector that has been recovering since 2011—have remained disappointing so far this year and will bear watching.”

Further, she reiterated her concerns about housing in the FOMC press conference last week. Those concerns are justified because home prices are closely tied to the health of the economy. Indeed, many consumers’ net worth impacts their confidence and their level of spending, a phenomenon known as the “wealth effect.”

However, we haven’t seen enough housing weakness to warrant the Fed becoming more accommodative any time soon. As we look ahead to this week, investors should pay close attention to indicators of housing-market health and signs of a further increase in inflation. We expect greater uncertainty and less direction in the stock market now that the Fed is looking at a mosaic of economic data rather than just unemployment.

While the mosaic approach may be a more appropriate way to determine when to reduce accommodation, it’s likely to cause confusion. It also may lead to some missteps by investors as they attempt to divine the Fed’s next move.


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Past performance of the markets is no guarantee of future results. This is not an offer or solicitation for the purchase or sale of any financial instrument. It is presented only to provide information on investment strategies and opportunities.


A Word About Risk
: Equities have tended to be volatile, involve risk to principal and, unlike bonds, do not offer a fixed rate of return. Foreign markets may be more volatile, less liquid, less transparent and subject to less oversight, and values may fluctuate with currency exchange rates; these risks may be greater in emerging markets.
 
The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

 
The Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics. There can be no guarantee that the CPI or other indexes will reflect the exact level of inflation at any given time.

Unless otherwise noted, index returns reflect the reinvestment of income dividends and capital gains, if any, but do not reflect fees, brokerage commissions or other expenses of investing. It is not possible to invest directly in an index.

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