U.S. rates – Waiting for the sound

Zach Pandl, Portfolio Manager and Strategist | May 5, 2014

  • Latest data showing faster growth and shrinking gaps.
  • Normalizing economy creates asymmetry in monetary policy outlook.
  • Fed officials might need to make a sound before interest rates move higher in more meaningful way.

By now it is widely appreciated that gross domestic product (GDP) is a deeply flawed tool for tracking economic growth. But the contrast between the Q1 GDP report and other available data on the economy was nonetheless remarkable. According to the Bureau of Economic Analysis, real GDP growth was just 0.1% annualized in the first quarter. Some analysts think this figure will eventually be revised into negative territory.

In contrast, our own measure of real economic activity—which uses a broader set of indicators than those included in GDP—suggests that growth never fell below 2% in Q1. Plus, the latest available data point to growth around 3% for both March and April (Exhibit 1). We are not sure whether the soft patch and subsequent rebound were caused by winter weather, but it seems a plausible story.

Exhibit 1: U.S. Activity Indicator (% annualized growth)

Pandl1

We have also seen further improvement in the all-important “gaps”—the difference between the unemployment rate and its structural rate, and the difference between inflation and the Fed’s target. Since the end of last year, the unemployment rate has declined to 6.3% from 6.7%, a period over which the labor force participation rate (LFPR) was unchanged at 62.8% (the LFPR rose in December through March but reversed those gains in April). The U6 unemployment rate has also declined to 12.3% from 13.1% in December. Separately, core PCE inflation edged up to 1.2% year-over-year from 1.1% previously. With a trend-like gain for April (and no revisions to prior months), the Fed’s preferred measure of core inflation will increase to 1.4% when reported on May 30.

It is these shrinking gaps that motivate our cautious views about duration risk. Importantly, we do not take issue with the fact that the Fed is still falling short of its inflation and unemployment mandates. Instead, the big question is whether policy remains appropriately calibrated given smaller gaps. In the 2008 transcripts there is a great quote about this issue from Atlanta Fed President Lockhart:

“I think an apt anecdote is a conversation I had in the past six weeks with a cruise line CEO who doesn’t know how to drive his ships but who has in fact been at the helm a couple of times. He said, ‘When you turn the wheel and nothing happens for several miles, the temptation to keep turning the wheel is overwhelming.”’ (April 29-30 2008 FOMC meeting)

Like the CEO driving the cruise ship, the Fed has turned the wheel further than is required to bring unemployment and inflation back to target. This creates an asymmetry in the outlook for policy.

If that is the case, why have interest rates remained so well-behaved? Besides Ukraine and the usual list of technical considerations, we think the main culprit is Fed communication. There is a lot of subjectivity to monetary policymaking, and the Fed’s reaction function has constantly evolved in the years since the 2008-2009 recession. As a result, we can’t be sure how policy will respond to the incoming data. Given weak wage growth, for instance, it is not obvious that the lower unemployment rate will lead to a shift in the Fed’s “dots” (their forecasts for the funds rate) at the June meeting. Bond investors are thus waiting for the Fed to make a sound—they need to hear that the stronger data and normalizing gaps are actually translating into a shift in the policy outlook.

Despite still-low wage and price inflation, we suspect that Fed officials will make that sound in the not-too-distant future. We are reminded of another quote from the 2008 transcripts. Here is Ben Bernanke at the January 21 meeting: “Inflation is a lagging indicator. We cannot wait until inflation is down before we begin to act. We have to look at the future.” Although inflation was then on the other side of the Fed’s 2% target, we suspect policymakers could be making similar points today. Unless their tolerance for overshooting inflation and financial stability targets is very high (a possibility), Fed officials will need to take on board the lower unemployment rate in their policy planning. We will therefore be looking for an uptick in chatter about the exit process in forthcoming Fed communication. If we don’t hear any, it will be a hint that only faster wage growth will bring the exit debate forward.