Fed Reaction: Markets Embrace Rate Decision But Questions Still Remain On When

It seems like déjà vu all over again with a tiny hitch. The Federal Reserve did what’s it’s done since December by leaving interest rates exactly where they are at a range between 0.25% and 0.5% but noting, without excuse, that though the economy is improving, today was not the day to hike rates.

“Near-term risks to the economic outlook appear roughly balanced,” the Fed statement said, changing from its determination in July that the risks had merely “diminished.” It added, however, this: “The Committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives.

Yes, once again, the statement makes it clear that rate hikes are still on the table. Does that mean December? Should the markets get ready for a holiday hike?

The stock market took note, moving to the upside after tipping in and out of positive territory from a solid open in the final hour ahead of the announcement.

The S&P 500 (SPX), which has subtracted about 2.4% since its record peak Aug. 15, returned to its early-morning gains that took it off that tight 2,139-2,140 range of the last three sessions and rose again during the press conference to flirt with the 2,160 level.

The statement noted, again, that economic activity is still growing at that “moderate pace,” but Chair Janet Yellen said in the press conference after the announcement that is was the slack in the labor force and that inflation is still short of 2% that were of primary concern to her.

“The employment to population ratio has also continued to increase,” Yellen said, “and we were not really certain that this is something that would happen as the labor market strengthened and it’s good to see that development has taken place…

“But policy needs to be forward-looking,” she added. Waiting to make sure these developments and what she called more “running room” in the labor market happened will keep the economy growing on an even keel, she said, is a more appropriate choice.

To that end, the Fed is taking on a more hawkish tone than it has all year, hinting that it’s preparing for a higher benchmark fed funds rate by the end of the year. When appears to still be a crapshoot. “Every meeting is live and we will again assess, as we always do, incoming evidence” by November and decide then, she added in the press conference.

The Fed’s Puzzle

There’s a conundrum that the Fed has been grappling with for most of this year, according to many economists and analysts. Remember, first, that the Fed has that dual mandate, established by Congress, to maximize employment and stabilize prices in an effort to create a steady monetary climate. Generally, in that type of environment, businesses aren’t afraid to expand, employees aren’t afraid to switch jobs, and economic growth continues.

Much of that appears to have panned out, as many economists and market watchers agree, but what is the prime point for all that? The Wall Street Journal notes that full employment, as measured by the Congressional Budget Office, is 4.8%, “the same as the Fed’s estimates in March and June, and a hair below the current jobless rate” of just below 5%. But Chair Janet Yellen has maintained that those rates might be underestimating the true picture, partly because of underemployment, what is known as “slack.”

“Part of the challenge for both sides (of the Fed rate debate) is that nobody knows where that sweet spot is—that is, how low the jobless rate can go and for how long before inflation starts to rise too much,” according to WSJ. Typically, a tighter labor force eventually pumps wages that then pushes inflation as prices rise. Is that happening?

“No one can prove them wrong, except for the fact that we keep coming around the corner and there’s no inflation,” Jared Bernstein, a senior fellow at the Center on Budget and Policy Priorities and a former Obama administration adviser, told the WSJ. Stay tuned.

Hawks Vs. Doves

The dissenting team got stronger during this vote but Yellen assured the media that “there is less disagreement than you might think,” given the difference of opinions Fed members have voiced in recent weeks.

“We’re trying to understand some difficult issues,” she added. “What is the new normal in this economy, and the global economy more generally, which explains why we keep revising down the rate path.”

Three of the committee’s 10 members supported by policy action, with Kansas City governor Esther L. George dissenting again, joined by Loretta J. Mester, president and chief executive of the Federal Reserve Bank of Cleveland, and Eric Rosengren, president and chief executive of the Federal Reserve Bank of Boston, each of whom preferred an aggressive hike of .50% to .75%.

Yellen noted during the press conference that their opposition was primarily rooted in their fears of the economy overheating and the labor market getting too tight too fast, which would dictate a faster-than-expected hike in interest rates.

The Credibility Issue

The debate goes on about the credibility of the Fed and it’s on again/off again communications issues. Some analysts complain that the Fed pays too much attention to the market reaction, while others insist that the Fed should be sensitive to the impact a rate hike has on markets, surprise or not. And then there’s the question of its political leanings in the run-up to the presidential election.

“I’m not going to get into politics,” Yellen said. “We do not discuss politics in our meetings. We had a rich, deep serious intellectual debate (today) about the risk of the economy and we struggled mightily to understand each other’s views and come out at a balance place to accommodate appropriately.

“I have no concern that the Fed is politically motivated,” she added.

The CME Group’s FedWatch Tool, which uses the Fed funds futures market to calculate probability of a rate hike, moved slightly higher toward one coming in December with a 59.3% chance during the press conference. That’s up from 58% ahead of the announcement.

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