The Federal Reserve has laid the foundation for a December rate hike.
Nobody we know was seriously expecting the Fed to raise rates today, with the election in six days and without a press conference scheduled for Fed Chair Janet Yellen to explain her thinking. Nonetheless, changes to the wording of today's release were almost entirely hawkish, a signal to markets to be ready in December.
That said, there were two items in today's report that may be touted by the pouting pundits as signs that the Fed could hold off on a hike before year-end. First, the statement included a change about household spending from "growing strongly" to "rising modestly". Second, Boston Fed president Eric Rosengren voted to keep rates unchanged despite voting for a rate hike at September's meeting. But we chalk this up to his wanting to avoid a rate hike so close to the election, not to any change of heart regarding the strength of the economy.
Baring these two modestly dovish notes, all of the remaining changes to the Fed statement point hawkish. The Fed noted that "inflation has increased somewhat since earlier this year," while also highlighting that market-based measures of inflation have moved higher in recent months. In addition, previous comments about the downward pressure of energy prices on inflation were removed altogether. But possibly the most direct sign that the Fed plans to hike in December came with the addition of a single word; the Fed is now waiting for "some" further evidence of progress towards full employment and 2 percent inflation. This tiny tweak in language suggests that they are acknowledging the largely positive data releases since the September meeting, while also lowering the bar for what is needed between now and December 14th for them to pull the trigger.
The dot plots released after the September meeting showed the majority of FOMC participants projecting at least one rate hike in 2016, and speeches by Fed members since that meeting have reiterated the outlook that a rate hike looks appropriate given economic conditions. Baring a serious surprise to the downside in employment or inflation (and we don't expect either), it's hard to see the Fed delaying much further.
In our view, economic fundamentals warranted a rate hike at the start of the year, and the Fed would have been justified to raise rates today. The economy can handle higher short-term rates. The unemployment rate is already very close to the Fed's long-term projection of 4.8% and nominal GDP – real GDP growth plus inflation – has grown at a 3.0% annual rate in the past two years. Moreover, we are starting to see early signs of accelerating inflation. "Core" consumer prices are up 2.2% versus a year ago, tied with the largest increase since 2008, while average hourly earnings are up 2.6% from a year ago, despite many highly paid and productive Baby Boomers exiting the workforce.
Slightly higher short-term rates are not going to derail US growth, but will help avoid the misallocation of capital that's inevitable if short-term rates remain artificially low.
Brian S. Wesbury, Chief Economist
Robert Stein, Dep. Chief Economist
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