Key Issues The FOMC Might Face In 2015 by Bill O’Grady and Mark Keller, Confluence Investment Management

Summary

  • The Federal Reserve will raise rates next year but in a very cautious fashion. We expect the first rate hike to occur next autumn and a target rate of 0.50% by year-end.
  • The economy will grow around 2.5%; consumption will remain sluggish as household deleveraging continues and net exports deteriorate. On the other hand, the government sector will become less of a drag on growth.
  • Our baseline forecasts for the S&P 500 for 2015 are earnings per share of $123.19 and a P/E of 17.7x, yielding a year-end price target of 2180.46. We assume that a recession will be avoided and so the most likely risk to our forecast is that we are too conservative.
  • We forecast the 10-year T-note yield to hold in a range of 2.15% to 2.40%. Current low inflation and low foreign yields, along with steady inflation expectations and a modest policy tightening, will keep yields mostly stable.
  • The dollar’s bull market should continue, driven by widening policy stances between the Federal Reserve and the European Central Bank and the Bank of Japan. Our forecasts are calling for a 1.170 $/€ and a 130 ¥/$ by year-end 2015.
  • Commodity prices will remain under pressure due to weaker Chinese growth and a stronger dollar.

Key Issues

Every year has its own particular concerns and this year is no different. We have identified three key issues: the anticipated change in monetary policy, the continued ambiguity of America’s superpower role and the 2016 presidential election. This report will only focus on the first issue. We recently addressed the superpower role in our 2015 Geopolitical Outlook,1 and the 2016 elections have already been addressed in earlier reports.2 We will note how the latter two issues may affect next year’s markets in this report, but the details of our thoughts have been discussed in the aforementioned reports. After completing our discussion on monetary policy, we will offer our expectations for the economy, equities, interest rates, foreign exchange rates and commodities.

The Change in Monetary Policy

Since becoming independent in 1954, the Federal Reserve has never targeted interest rates this low or held rates steady for this long.

FOMC

As this chart shows, the Federal Open Market Committee (FOMC), the body that sets interest rate policy, has never engaged in the sort of policies that we have seen since 2009. This situation creates significant uncertainty. For instance, keeping rates at this level for this long may have inadvertently caused parts of the economy to become increasingly sensitive to small changes in interest rates. Thus, will homebuyers be willing to accept higher mortgage payments if interest rates rise, or have they become so accustomed to low rates that a small increase dampens housing activity or forces sellers to reduce their asking prices? Will modest increases in deposit rates send savers flocking back to low-risk money markets and certificates of deposit, draining cash from other markets?

In addition to conducting the Zero Interest Rate Policy (ZIRP), the FOMC has also engaged in expanding its balance sheet, a process known as “quantitative easing” (QE).

FOMC

The Federal Reserve’s balance sheet, which was $870 billion in August 2008, is now $4.4 trillion. The FOMC added to its balance sheet in three
stages (QE1, QE2 and QE3), marked as the gray bars in Chart 2. The latest phase has just ended.

The FOMC is considering changing policy due to improvements in the labor markets. The Federal Reserve has two mandates-controlling inflation and achieving full employment. For much of its history, the central bank has avoided placing numeric goals on either number to maintain policy flexibility. However, in light of the general trend toward transparency, the Federal Reserve has established unofficial targets for both numbers—2% for the core personal consumption expenditure deflator (core PCE) and 6% for the unemployment rate.

Although the long-term relationship between unemployment and inflation is rather inconsistent, since the mid-1990s, unemployment below 6% has tended to coincide with the core PCE deflator rising to the target inflation rate or above. Now that unemployment has broken 6%, the majority of FOMC members are leaning toward raising rates next year.

FOMC

FOMC

This chart, from the December FOMC meeting, shows that the vast majority of committee members believe that the policy rate should rise next year. Since inflation remains well below target, we can only conclude that the improvement in the labor markets is prompting  the expectation of tightening monetary policy.

Implicit in this conclusion is our presumption that a majority of the FOMC believes that there is presently a “taut rope” between improving labor markets and inflation. We doubt that the “rope is taut.”

However, this outlook is not universal because it isn’t clear whether the unemployment rate is correctly measuring the degree of slack in the economy.

FOMC

This chart shows the unemployment rate along with the employment/population ratio on an inverted scale. From 1980 to 2010, the two series closely tracked each other; when the unemployment rate fell, the employment/population ratio improved. That correlation has not been the case in this recovery. The difference between the unemployment rate and the employment/population ratio represents nearly 7.5 million jobs. If those workers remain available to the economy, we could see higher growth without the sort of constraints that lead to inflation.

Unfortunately, a number of studies suggest this gap may be a permanent part of the economy. Some of the gap is due to the retirement of baby boom workers, while skill and location mismatches also keep potential workers out of the workforce. We tend to think that strong growth may narrow the gap somewhat, but the labor markets are probably tighter than the employment/population ratio would suggest. At the same time, the employment/population ratio does suggest that there are problems in the labor markets which may act to keep inflation under control. And so, an aggressive rate tightening cycle may not be necessary.

With this much uncertainty, why should the FOMC raise rates? It all comes down to available “slack” in the economy. There are numerous models one can use to determine the neutral rate for fed funds; one of our favorites is from Greg Mankiw. The Mankiw Rule is a simplified version of the Taylor Rule; both attempt to estimate a neutral policy rate based upon inflation and the level of underutilized capacity in the economy. The latter uses the difference between actual GDP and an estimate of GDP with fully utilized factors of production (potential GDP). Potential GDP is not directly observable and thus there is a good deal of uncertainty as to the actual degree of slack. Mankiw’s original model used the unemployment rate as his proxy for economic slack. We have created our own versions of his model; one uses the unemployment rate while the other uses the employment/population ratio as measures of slack.

FOMC

The two variations generate significantly different results. Using the unemployment rate, the model’s projected policy

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