When it comes to the target range for the federal funds rate, it's a matter of when it is going up, not if it is going up. From our vantage point, we think that target range is going to be increased at the March 14-15 Federal Open Market Committee (FOMC) meeting.
Our viewpoint was a minority viewpoint only a week or so ago, yet much has changed in the interim, such that our viewpoint is now the majority viewpoint.
When the minutes from the January 31-February 1 FOMC meeting were released on February 22, we said on our Fed Brief page that the market should consider itself warned that the Fed could raise the target range for the fed funds rate sooner than expected.
We said as much pointing to the passage in the minutes that noted, "...many participants expressed the view that it might be appropriate to raise the federal funds rate again fairly soon if incoming information on the labor market and inflation was in line with or stronger than their current expectations or if the risks of overshooting the Committee's maximum-employment and inflation objectives increased."
That declaration notwithstanding, the probability of a rate hike in March continued to linger below 30%, according to the CME's FedWatch Tool. At the moment, that probability stands at 75.3%.
The sudden, and remarkable, shift in rate-hike expectations can be attributed to several factors:
- Fed officials increasingly touting the idea -- both directly and indirectly with their language -- that the target range for the fed funds rate could be increased at the March meeting
- The stock market's inexorable climb to record highs, which has driven up animal spirits and valuations (and presumably the Fed's attention to such matters)
- The four-week moving average for initial claims hitting its lowest level (234,250) since April 14, 1973; and
- The PCE Price Index increasing 1.9% year-over-year in January, which is close to the Fed's longer-run inflation target of 2.0%
That PCE Price Index was one of three economic releases we identified as a focal point for determining if the Fed would in fact raise the policy rate at its March meeting. The other two were the February Employment Situation Report (released March 10) and the Consumer Price Index Report for February (released March 15).
We no longer think there is as much riding on the latter two reports when it comes to the March rate-hike decision. A rate hike in March should be a done deal barring an absolutely dismal reading for average hourly earnings in February.
The primary reason we think a rate hike should happen is that the stock market is effectively telling the FOMC to raise the target range for the fed funds rate. We'd argue that it was saying as much even when the probability of a rate hike in March was below 20%.
That thinking is rooted in the enduring leadership of the cyclical sectors this year, which has been a reflection of the stock market's belief that stronger economic growth lays ahead.
Promises from the White House of tax reform, infrastructure spending, and deregulation have fueled that belief along with various consumer confidence readings, healthy nonfarm payroll gains, improving growth abroad, corporate earnings growth, and rising futures prices for industrial metals and lumber.
The stock market gains across sectors and market-cap sizes has been impressive. On another level, they have been akin to a window of rate-hike opportunity opening up for the FOMC.
The FOMC has missed such windows of opportunity in the past. We don't think they can, should, or will pass it up this time around knowing the stock market looks exceedingly comfortable with its mental state of expectations.
To wit, the stock market had its best day of 2017 on the same day the probability of a rate hike at the March meeting shot up close to 70%.
That performance, among other things, validated the notion that the stock market isn't afraid of a rate hike at this juncture, because it recognizes the fed funds rate will be going up for the right economic reasons and not simply on account of a veiled attempt by the Fed to get some rate-cut insurance in its back pocket.
What It All Means
Could U.S. economic growth be stronger? Absolutely. Is there uncertainty about the evolution of fiscal policy in the U.S. and the election cycle in Europe? You bet.
Even so, GDP growth, the PCE Price Index, financial conditions, and unemployment are not at emergency levels. By extension, the fed funds rate should not be either.
The Federal Reserve's path to normalization should pass right through the window of opportunity the stock market has opened up for the FOMC ahead of its March meeting.
It's in the cards, it's in the stock market, and it should be in the next policy directive.