The Fed’s Tightrope

July 18, 2017

With the release of June’s inflation numbers coming in soft against expectation, the Federal Reserve is playing a careful balancing act. Historically when the Fed decides to raise rates, they happen quickly and consistently on average. However, since the financial crisis, each incremental raise has been small and very carefully measured against the economic backdrop. If the data continues to be weak, it could give the Fed pause in their current trajectory for raising rates.

 

The Federal Reserve’s dual mandate is to foster conditions that achieve both stable prices and maximum sustainable employment. With unemployment below historical averages, the Fed has little work to do when it comes to “maximum sustainable employment.” This leaves the inflation prong of their mandate to garner our attention.

 

For most of their history, the Federal Reserve had to combat high inflation. In a normal economic expansion, lending would increase and with additional funds in the economy, prices would rise. Sometimes this happened too quickly and the Federal Reserve would raise rates to slow down the pace of lending and ultimately slow down inflation. However, during this expansion, inflation has stayed stubbornly low and is making it difficult for the Fed to “normalize” rates.

 

June will be the fourth month in a row now where inflation has come in under expectations. Year-over-year inflation numbers in June stand at 1.7% and have slipped from their highs back in February of 2.3%. The disappointing numbers will raise some questions if the Federal Reserve should even raise rates again this year.

 

This is frustrating for the Federal Reserve as they are trying to prepare for the next crisis. When they lowered interest rates essentially to zero, they effectively emptied the cupboard to fight the financial crisis. When that proved to not be enough, they threw the kitchen sink at it as well in the form of quantitative easing. With quantitative easing being unwound, their attention has turned to restocking the cupboard. Yet with inflation struggling to gain any traction, it is difficult for them to raise rates without compounding the problem and potentially slowing growth further.

 

While the Federal Reserve carefully navigates sustaining today while also preparing for the future, there are a few implications for us as investors. Most likely market rates will not increase at an accelerated rate. The current economy is too fragile to make any sudden moves and the Fed respects that. Deflation also continues to be a risk that many in the market are not talking about. With inflation so low, we are potentially a crisis away from re-entering a deflationary scare. As we have argued previously, the current economic environment is deceptively calm and now is not the time to be aggressive. Unlike the Fed, it is easy for us to keep the cupboard stocked right now with a carefully crafted asset allocation to handle whatever may come next.

 

 

 

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