Market Update - Learning From History

With a very uncertain election upcoming, the only thing really certain was that the FOMC was going to leave rates unchanged today. Eight members voted to leave rates unchanged and there were two dissenting votes for a 25bps rate increase. Recall at the last meeting there were three dissenting votes. The Fed stated that inflation is on track for their 2 percent target. The 10yr currently sits at 1.80%, up 15bps since the last FOMC meeting.

For the last few years there has been constant speculation as to when the Fed would raise rates, and for the past seven years the Fed has only moved rates once. In fact, in the past 10yrs, December 2015 was the last time they raised rates (June 2006 was the time prior). Now what about the psychology behind the Fed? If each Fed meeting is a judgement call, why do they constantly hold back at the FOMC meeting despite the constant talk prior about making a move? Maybe history was a good lesson.

In January of 1996 the unemployment rate was 5.6%. Relative newcomer Janet Yellen shared her concerns with FOMC Chair Alan Greenspan that if the key interest rate isn’t raised, then inflation could raise materially if and when the jobless rate drops. Greenspan decided ultimately to leave rates unchanged and over the next 4 years the jobless rate dropped to 3.8% (the lowest in 30 years). What was so interesting about that time period was that inflation moved very little and Greenspan was proven right. Fast forward 20 years from that meeting in September 1996 and now Janet faces the same quandary that Greenspan faced. The pressure to raise rates in the face of a falling unemployment rate and the potential that inflation might grow beyond anything reasonable. The advantage that Yellen has today is the fact that all signs point to an inflation rate that is struggling to attain the 2% target, as well as inflation around the globe that is very low and sticky. Arguably, Alan Greenspan had a tougher decision to make than Ms. Yellen but the pressure is still the same. Move too early, and possibly create a recession and then have to reduce rates, or wait too long and cause uncontrollable inflation and/or asset bubbles. It’s a tough call but if you are willing to admit that inflation is really struggling and won’t race out of control, it’s actually a relatively easy decision.

Regardless, the Fed comments today are really no different than the story they have been painting. All signs point to a December hike and the possibility of two interest rate increases in 2017. The odds for December are trading at a high today of 76%, but the market only sees one increase next year. The election is still a wild card and the bond market would likely trade higher on a Trump presidency while the stock market trades positive on the prospect of a Clinton presidency.

See below for Fed Funds Rate versus Inflation (CPI YoY) and the Unemployment Rate since right before the Financial Crisis. Note the continual drop of the unemployment rate (in grey) whilst the Fed Funds rate stays near zero (in orange) and the fact that inflation hasn’t stayed consistently above 2% since 2011 (in blue).

Fed Funds Rate versus Inflation (CPI YoY) and the Unemployment Rate