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We're spending way too much time worrying about the Fed

Those who think the U.S. Federal Reserve should be raising interest rates aren't getting a lot of help from the data on which the central bank professes to be so dependent.

Tuesday brought a fresh batch of economic weakness on which the Fed can feast. The ISM non-manufacturing index plunged to a six-year low reading of 51.4, a number that provides a double gut punch to the economy after last week's manufacturing reading showed a stunning outright contraction in that sector. (The non-manufacturing reading indicates the sector is still barely in expansion.)

The release quickly tanked market expectations that the Federal Open Market Committee, during its meeting Sept. 20-21, might enact the second rate hike since December. Traders now put just a 15 percent chance on a move this month, and actually now don't believe the FOMC will hike at all this year, reducing December's probability to 46.9 percent.

Coupled with other recent weak data points, Tuesday's ISM number "should all but rule out any possibility of a September rate hike," said Paul Ashworth, chief U.S. economist at Capital Economics.

One of the big reasons: Even though trackers, such as the Atlanta Fed's, show third-quarter GDP growth coming in north of 3 percent, the ISM readings are consistent with something on the lines of 0.5 percent.

"The mistake we made in the second quarter was trusting the incoming monthly activity data we had that, right up until the last minute, pointed to a strong showing from second-quarter GDP growth. In contrast, the surveys were pretty weak and suggested that growth wouldn't be much above 1 percent annualized," Ashworth said of a period where growth was just 1.1 percent. "This makes us very nervous for the third quarter."

Janet Yellen
Drew Angerer | Bloomberg | Getty Images

Still, the drumbeat for a hike likely will continue.

Fed critics, including Janus Capital bond guru Bill Gross and others, boil their rate hawkishness down to three main concerns:

  1. Central bank policy has hampered growth by inciting fear and demanding that savers put aside more to compensate for lower yields.
  2. To paraphrase Mohamed El-Erian, chief economic adviser at Allianz (and former cohort with Gross at Pimco), the policies have encouraged risk-taking in financial markets but discouraged it in the private economy. In other words, the concern is that low rates and $3.8 trillion of money printing has ballooned stock market valuations at the expense of organic economic growth.
  3. Crisis-era policies simply aren't warranted anymore, and they handcuff the Fed for when another actual emergency comes into play.

"Looking at the flow of the data over the past few months, it is easy to argue that a rate hike now doesn't make much sense," said Peter Boockvar, chief market analyst at The Lindsey Group. "However, why are short-term interest rates now about where they were during the Great Depression in the early 1930s as we approach year eight of this economic expansion?"

Boockvar believes monetary policy has gone "off the rails" with its ultra-accommodative stance, which is kept in place even though the Great Recession was proclaimed over more than seven years ago.

Still, the anti-rate hike crowd — Fed Chair Janet Yellen is its most important member and holds something just shy of veto power — has prevailed.

Tom Porcelli, chief U.S. economist at RBC Capital Markets, in a note over the weekend offered up the case for doves, even though he has said the economy is strong enough for the Fed to hike:

  • The U-3 unemployment rate (the one most widely talked about) is flat (4.9 percent) while the U-6 (the broadest measure) has improved by a grand total of 0.2 percentage points this year (from 9.9 percent to 9.7 percent).
  • The labor force participation rate is essentially flat at 62.8 percent, and even the more "cyclical" measure (for the 25-54 year-old cohort) is only up a modest 0.2 percentage points from 81.1 percent to 81.3 percent.
  • The number of folks working part-time for economic reasons has moved sideways all year.
  • The share of those unemployed for 27 weeks or more is 26.1 percent from 26.3 percent in December.
  • Average hourly earnings are sitting at +2.4 percent growth year over year — they were at +2.5 percent in January.
  • The quit rate is unchanged since Jan at 2.0 percent.

Also, headline inflation as measured by personal consumption expenditures is only around 1 percent, though core (excluding food and energy) is about 1.6 percent — both numbers well below the Fed's 2 percent target.

Porcelli believes there's little on the horizon in the next two weeks that will move the Fed from its dovish position.

"We have been asked what other reports between now and the September meeting could sway the Fed," he said. "Here is our answer to that. It is a sad state of affairs that folks think (courtesy of the Fed) that the fate of what to do in September hinges on any one report."

Indeed, Yellen and her dovish majority on the FOMC aren't moved by any one report. Instead, they are motivated by a belief that the risks of tightening policy, even ever so slightly as a quarter-point hike, outweigh the risks of staying pat.

Until something significant changes, that's likely going to outweigh clamoring for normalization.