The Fed's balancing act

Although some market participants are disappointed by the Fed's further delay in raising interest rates, the key issue for markets is not when hikes begin, but how quickly they proceed once they begin. Once hikes begin, monetary accommodation will be removed at a pace that is expected to be "gradual." The Fed's dot chart tells that that FOMC members expect interest rates to eventually climb above 3%, perhaps as high as 3.5%, unless inflation overshoots, in which case they could do more, or declines unexpectedly, in which case they could do less.

The market's expected path of the funds rate reveals an even more "gradual" pace than the FOMC's projections. For example the 1-year swap rate, 5-years forward is 2.71%. Forced to choose between acceleration in inflation or a renewed slump, the market leans pessimistic.

Yesterday's (September 17) Fed decision was a close call. The labor market did make "some further improvement" since July. But confidence that inflation will move steadily toward 2% in the coming quarters eroded, based on falling commodity prices and increased concerns about global growth. It is worth examining each of these things in order to understand why the Fed saw the balance of risks justifying a delay.

"Good news in the labor market came in a variety of forms. The unemployment rate dropped to 5.1%, just above the Fed's newly-revised 4.9% long-term expected level. Payrolls growth was steady. Nominal labor income accelerated modestly and has grown faster than 5% annualized so far this year. Initial claims remained historically low. And the JOLTS delivered the news that job vacancies have soared recently. If we take labor demand to be the sum of filled and unfilled positions (proxied by total payrolls plus total job vacancies), the growth of total labor demand has been very robust", says Credit Suisse.