The Fed: No Rush to Raise Rates

July 30, 2014 4:56 PM
By Zane Brown

Continued softness in the labor market may be keeping the central bank from raising the fed funds rate sooner than mid-2015. 

Investors focused on the July 30th meeting of the Federal Reserve’s policy-setting arm, the Federal Open Market Committee (FOMC), for confirmation that the Fed was on track to end its quantitative easing (QE) program by October 2014. They weren’t disappointed. As expected, the Fed announced an additional $10 billion reduction in monthly bond purchases (down to $25 billion per month), moving it closer to the taper-free zone so anticipated. But what market watchers didn’t receive was a clear signal that the Fed was prepared to start raising interest rates ahead of schedule (in 2015). 

In a statement that followed the meeting, the Fed said it would maintain the current target range of the fed funds rate, 0-0.25%, "for a considerable time" after QE ends, especially if projected inflation remains below the Fed’s 2% objective. That timetable, however, did not sit well with one FOMC member, Philadelphia Fed president Charles Plosser, who, as my colleague Milton Ezrati notes in an upcoming Economic Insights, has been described as the "north pole of hawks on inflation." Plosser voted against the Fed’s policy action, objecting to the "considerable time" phrasing "because such language is time dependent and does not reflect the considerable economic progress that has been made toward the Committee's goals."

This is not to say the Fed failed to acknowledge an improving economy. The statement cited a rebound in economic conditions in the second quarter, noting that that "there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions." But the Fed’s view of a strengthening economy was tempered by an acknowledgement of "significant underutilization of labor resources," which may have tipped the scales toward a continuation of the low-rate regime.

The Fed’s communiqué followed a report earlier on July 30 from the Labor Department on initial gross domestic product (GDP) for the second quarter. The report showed the economy growing at a rate of 4%, with the negative showing for the first quarter revised from -2.9% to -2.1%. Coupled with recent congressional testimony by Fed chairwoman Janet Yellen referencing the central bank’s potential response to stronger growth, many investors may have anticipated some acknowledgement that the Fed might respond to acceleration in GDP by adjusting interest rates earlier than the widely expected timeframe of mid-2015. Much like Plosser, these investors may have been somewhat disappointed in the Fed’s decision to stick with the "considerable time" language.

Even without Fed corroboration of investor expectations, yields on higher credit-quality securities have started to rise in anticipation of an eventual Fed move, with the yield on the benchmark 10-year Treasury note climbing 8 basis points, to 2.54%, in afternoon trading on July 30, according to Bloomberg. As the time for Fed action shortens, investors also may expect to see greater interest in securities likely to perform better in periods of rising rates and economic strength, such as issues with shorter maturities and more credit-sensitive debt. 

As the week unfolds, investors will be focused on the U.S. employment report scheduled for release on Friday, August 1, for confirmation of the strength signaled by the second quarter GDP number.

Zane Brown is a Lord Abbett Partner and Fixed Income Strategist.

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