Well, they did it! Of course, this was nearly universally expected, so not much to say on that front.
I've been saying for months now that one interest rate hike by the Federal Reserve in 2015 was priced in. It was all about how fast rate hikes come in 2016. They said "gradual" in the statement, but that is what everyone expected as well.
There are two key parts of today's release that give us some more concrete clues about 2016: their economic projections and the "dot plot."
Economic projections are broadly unchanged.
The Fed's economic projections were basically unchanged from the September Summary of Economic Projections (SEP). The median GDP projection for 2016 ticked up 0.1% but 2017 and 2018 were the same. Core PCE (a measure of inflation) was estimated 0.1% lower for 2016, but also unchanged for 2017 and 2018.
What is notable is the slight downward revision in the unemployment rate projection. The Fed is projecting 4.7% for year-end 2016 and the same figure for 2017 and 2018. That is interesting on a couple fronts.
First, it implies that the Fed thinks about 4.7% is full employment, because it is projecting only a slight increase in inflation in the coming years. Traditional economics holds that if we get much below the full employment level, wages and inflation will start to rise quickly. But we can't directly observe what that level is. So, the Fed is left guessing, watching what wages do as unemployment ticks lower.
I believe even more interesting is their implied presumption that unemployment can stay at about the same rate for the next three years. We are already at 5.0%, so for unemployment to only move 0.3% in 2016 and then not change at all for two more years would require one of two things.
Either job gains would have to slow to equal the rate of labor force increase (around 75,000/mo) or the labor force participation rate would have to start rising. I find either situation hard to believe. Historically, the economy has never been able to add jobs at a rate equivalent to 75,000/month for an extended period of time. Why? Because if growth slows to that degree, we hit a stall speed and growth turns negative.
On the labor force participation, which is basically the percentage of adults either working or looking for work, this has been consistently declining for the last five years. There has been no rebound at all despite the significant improvement in hiring. I can only conclude that the problem holding LFP down is more about demographics and skills mismatch. I don't see either of those issues changing in 2016 or 2017.
That is why I don't see any chance that we just hold around 4.7%. If we keep LFP constant and assume we end the year at 4.7% unemployment, that implies job gains around 160,000/month in 2016. Even that might be below stall speed, but it is at least plausible. But even at that path, we'd blow through 4.7% in 2017, which means that the pace of Fed rate hiking would be picking up sometime during 2016.
I'm saying either things get better and the Fed hikes faster, or things get worse and the Fed doesn't hike much at all. That might not be evident until the middle of 2016, but it's coming.
The dot plot medians are about unchanged, but there is notable movement within.
The median dot for 2016 was at 1.375%, the same as September. But there is greater consensus. In September, there were four members above 2% and one at negative 0.125%. In between, members were all over the place. There are now seven members at 1.375% and 12 (a majority) between 1.125% and 1.625%. It is worth noting that the lowest member is at 0.875%.
That 0.875% number is notable because that's the market's expectations, based on where fed funds futures are trading. To me that means there is much more risk to an upside rate surprise than a downside surprise.
Quick Notes on Market Reaction
- Stocks and credit doing well: I'm shocked because oil is getting killed. Unless oil reverses, I'd expect credit to turn south again in the next few days.
- MBS crushing Treasuries: I suppose the MBS market is taking the tighter dots as meaning less volatility.
- Curve much flatter: 2-year bonds are above 1% for the first time since 2010, whereas 10-and 30-year bonds are unchanged.