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3 reasons a Fed rate hike is off the table till 2017

The odds of a Fed interest-rate hike in 2016 have decreased over the past week, and not just because of Friday's job report. In fact, the odds of a rate hike by the December meeting are now down to just over 40 percent, according to the CME Group's FedWatch Tool (which uses Fed Fund Futures prices to predict monetary policy). It seems like just yesterday that a December rate hike, at the latest, was pretty much a done deal. So what's driving the reduction in expectations?

It should first be noted that the reasons behind the Fed's about-face are less important than its predictable propensity to revert back to a dovish posture at the first sign of trouble. It is true that the Fed's "highly accommodative" monetary policy was appropriate in the immediate aftermath of the financial crisis. Desperate times called for desperate measures.

But its unwillingness to begin the normalization process in earnest is creating significant risks for the long-term health of the economy. Having said that, we think three issues will cause the Fed to defer rate hikes until 2017: deteriorating economic data; the spike in 90-day LIBOR; and increased election uncertainty.

First, incoming economic data has deteriorated over the past few days. The employment report for August, which was released last Friday, was weaker than expected. Not only did job growth drop materially, but wage growth was the slowest since March and the average work week was the lowest since February, 2014. Taken collectively, these data points don't reflect the fairly popular narrative that the labor market is approaching full employment.

There is clearly still some slack in the labor market despite the low unemployment rate of 4.9 percent. This week we learned that the ISM Non-manufacturing Index (aka the ISM services index), which came in at 51.4 for August, was the lowest since February, 2010.

Why is this important? Because services represent the lion's share of our economy. In fact, the services sector accounted for 150,000 of the 151,000 jobs created in August, according to the U.S. Labor Department. And while a reading of 51.4 is still above the line of demarcation between expansion and contraction (which is 50), the rapid slowing does not engender confidence when viewed in combination with the ISM Manufacturing Index reading for August (which did fall into contractionary territory).

Could the deterioration in these readings simply represent some combination of a seasonal slowdown, Brexit worries and election jitters? Sure, but the evidence certainty doesn't support the case for near-term interest rate increases by the Fed.

Another issue causing concern inside the Fed is the recent spike in 3-month LIBOR, which is the rate at which banks lend to each other for 90 days. The spike in LIBOR is being attributed to the imposition of new regulations for money market funds. These new regulations are expected to reduce the odds of a future financial crisis by establishing limits and penalties on redemptions under certain circumstances.

However, as a result of the new rules, money-market fund investors have opted to avoid the affected "prime" funds, at least until the new regulations become effective. Investor withdrawals have caused the 3-month LIBOR rate to increase to 0.83 percent, which is up over 20 basis points from levels in late June. Why is this important?

The spike in LIBOR represents a tightening in financial conditions because it is used as a benchmark for a whole host of floating-rate loan products for both consumers and businesses. Given that the new money-market fund rules don't go into effect until October 14, it seems highly unlikely that the Fed will choose to increase interest rates prior to that time.

And finally, we come to the election. Although we continue to believe that the market is pricing in a Clinton victory, the uncertainty surrounding that outcome appears to have risen in recent days. According to a new CNN/ORC Poll, Trump is now leading Clinton by 2 percentage points among likely voters. If Trump were to win, the surprise could prove destabilizing for the markets.

The potential for election-related disruption is undoubtedly one of the factors driving Fed decision-making as the election approaches. As such, we think a September rate hike is clearly out of the question. The confluence of other factors makes December much less likely as well.

Nobody wants higher interest rates, and this makes monetary-policy normalization (ie, interest-rate hikes) a very difficult thing to do. Because of the unpopularity of its job, the Fed will always be able to find excuses to avoid doing its job. In our view, the Fed has dramatically expanded the preconditions for policy normalization far beyond what should have been expected.

It's unwillingness to make difficult and unpopular decisions has reduced our longer-term economic growth prospects. Put in simpler terms, the Fed continues to, predictably, paint itself into an increasingly precarious corner. Investors should maintain a defensive stance as this drama plays out.


Commentary by Michael K. Farr, president of Farr, Miller & Washington and a CNBC contributor. Follow him on Twitter @Michael_K_Farr.