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By HaleStewart March 19, 2017 8:08 am
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US Bond Market Week in Review: We're Now at the Top End of the Natural Rate of Interest

    As predicted by, well, everybody, the Fed raised interest rates 25 basis points on Wednesday.  Let’s parse their statement:

Information received since the Federal Open Market Committee met in February indicates that the labor market has continued to strengthen and that economic activity has continued to expand at a moderate pace. Job gains remained solid and the unemployment rate was little changed in recent months. Household spending has continued to rise moderately while business fixed investment appears to have firmed somewhat. Inflation has increased in recent quarters, moving close to the Committee's 2 percent longer-run objective; excluding energy and food prices, inflation was little changed and continued to run somewhat below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.

The Fed specifically references establishment job growth and the unemployment rate to argue the labor market is close to full employment.  This is consistent with some Fed governors public comments.  But it ignores the low rate of labor utilization as evidenced by the higher U-6 rate and the lower labor force participation level:

Also of consequence is the weaker pace of wage growth, also highlighted in the chart above.  Neither weaker utilization nor diminished wage growth is fatal to the Fed’s belief that the U.S. is at or near full employment.  Retiring baby boomers and increased education are responsible for a large percentage of the drop in the participation.  The former is simple demographics in action while the latter could lead to increased productivity should it come to its logical conclusion.  However, the fact remains that those taking a dovish stance are supported by some labor market statistics.

Personal consumption expenditures rose 3% Q/Q in the 2nd revision to 4Q GDP.  While retail sales rose .1% in the latest report, they increased a healthy 5.7% Y/Y.  Both of these measures of consumer demand continue to proceed in strong uptrends: 

Although business investment in equipment did increase 1.9% in the latest GDP report, this was the first increase in the last 4 quarters; arguing this metric has “firmed somewhat” is a bit of a stretch.  As for prices, according to this table from the Cleveland Fed, all main measures of CPI are now over 2%:

Energy prices reversing their previously deflationary contributions are the primary culprit behind rising price pressures.  If this week’s oil price decline continues, then the current inflationary upswing will dissipate in the medium term.

    In short, there is ample evidence to support a rate hike at this point, which is exactly what the Fed did.  However, there may be a problem.  The current Fed Funds level is at the top end of the natural rate of interest, as calculated by the San Francisco Fed:

We can’t observe the “natural rate of interest;” instead, it must be calculated from a model.  But the SF Fed chart uses several different methodologies to compute this figure; the solid line at ~.5% is the average of all the models, indicating there is actually a fair amount of agreement between them.  Assuming these models are correct, then the current level of interest rates is at the top end of the range.  Unless the basic model increases in the near future, an additional rate hike would be constrictive.

     Food for thought.   

Hale Stewart is a tax lawyer in Houston, Texas with the Law Office of Hale Stewart, where he specializes in domestic and international tax structures and asset protection.  He is also a financial adviser with Thompson Creek Wealth Advisers. 


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