The market is waiting for the FOMC statement to come out on Wednesday, March 18, 2015, with bated breadth. Last week the market participants were quite busy reading the FOMC tea-leaves to ascertain when would FOMC remove the word “patient” from its policy statement. Would it do this in the coming meeting or in April or later? Apparently, the removal of this phase will clear the pathway for the fed-funds rate hike. The next objective of the tea-leaves readers would then be to guesstimate the timing and duration of rate-hikes. And, I do mean guesstimate, which is more dependent upon guesswork than calculation.
Let’s see how this word-game turned out when the Fed played it the last time.
The post dotcom bubble recession hit the U.S. in Q1 2001 and Fed started to cut fed-funds rate in January 2001 from the then high of 6.5%. In that rate-cutting cycle, the rates eventually bottomed out to 1.0% in June 2003.
Six months later, in its Dec. 9, 2003 statement, the FOMC included the sentence, “However, with inflation quite low and resource use slack, the Committee believes that policy accommodation can be maintained for a considerable period”. The phrase, “considerable period”, was used in three previous FOMC statement in 2003.
In the next meeting, Jan 28, 2004, FOMC replaced “considerable period” with “patient”. This word was repeated in March 16, 2004 statement but was replaced with “measured” in May 4, 2004, which included, “At this juncture, with inflation low and resource use slack, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured”. Fed increased the rate in the meeting after it used the word “measured”.
So, the big question that is flummoxing the market is will the Fed behave similarly this time too? Or in other words is it different this time?
Let’s note similarities and differences.
Inflation, Funds Rate and Unemployment In 2004
In 2004, when the Fed replaced “considerable period” with “patient”, the policy rate was 1.0%, headline inflation as measured by personal consumption expenditures (PCE) price index was near 2.0%, and the unemployment rate was around 5.7%.
The policy rate had been at 1.0% since June 2003, when it was reduced from 1.25 % set in November 2002. The unemployment rate peaked at 6.3% in June 2003 and was coming down.
And, the PCE was generally up-trending since the January 2002 reading of 0.7%. It was 2.0% in September 2003, 1.8% in October and November and 1.9% in December. It reached 2.0% in January 2004 and by the time of rate hike in June 2004, it was at 2.8%.
This is how the graph looked.
Inflation, Funds Rate and Unemployment In 2015
As of now the policy rate is between zero and 0.25 percent. The PCE is near 0.2% and the unemployment rate is near 5.7%.
This time the policy rate has not changed since Dec 2008. The period of low rate has lasted longer than that in 2004 reflecting worse recession.
The unemployment rate peaked at 10.0% in October 2009 and has been gradually coming down. In 2004 when the wording was changed, the unemployment rate declined to 5.7% from 6.3% in seven months. This time also, the unemployment rate has reached 5.7% seven months after recording 6.3%. So as far as the unemployment rate is concerned we are in similar conditions.
The biggest difference is on the inflation front. The PCE has been either declining or staying range bound since 2012. Recently, the direction is down rather than up to the target of 2.0%.
Here is the graph.
Dollar Index, Commodities, Bonds and S&P 500 Then
During 2003-2004 timeframe:
- The dollar index was in a free fall after making a double top in January 2002. By the end of 2003, it was trading at eight-year low levels.
- The commodities, as represented by the Goldman Sachs Commodity Index, were rising. The index bottomed by the end of 2002 and then was on an uptrend. it had made a then all-time high in February 2003 and after a brief retracement was again nearing that level by early 2004. It crossed that high level by March 2004.
- The S&P 500 was on an uptrend since early 2003. Prior to that trend, it had declined significantly after peaking in 2000. It bottomed in September 2002 and the tested the lows in the first quarter of 2004.
- The 30-year Treasury Yields, $TYX, were in decline since early 2000. They had fallen to multi-year lows near 4.03% in the Summer of 2003. They subsequently rose to 5.3% in August 2003 and then again started a downward slide.
In 2015, these indices are tracing a somewhat different pattern.
- The dollar index is on a tear. It has gone up parabolic and is trading at the highest levels in 13-years. It has been on an uptrend since 2011, which strengthened a lot since the middle of last year. This is complete opposite of its pattern in 2003-2004 period.
- The commodities are in strong down trend. The Goldman Sachs Commodities index was range bound from mid-2001 to mid-2014 but then it broke down significantly and is now trading at the lowest levels in five years. Like dollar index, it too is making a pattern opposite of that it made in 2003-2004.
- S&P 500 is making all time high. It has been on a strong uptrend since 2009. Its pattern is also a lot different and stronger than that it made in 2003-2004 period.
- The 30-year yields are still in a down trend. It is much below the levels that it reached in 2003-2004.
Bottom Line or the So Called Conclusion
The economic situation in 2015 as depicted by the unemployment rate is similar to that in 2003-2004 period but the inflation is not. The commodities index is also not showing any indication of heating up, rather, it is showing deflationary pressures.
The dollar index was declining in 2004, which meant that U.S. economy was more competitive and had room for interest rate hike. Now, the index is very high and is rising. This demonstrate the U.S. economy’s strength but it is also making export and labor cost uncompetitive compared to the rest of the world. Interest rate hike is going to exacerbate them.
The 30-year treasury yields are telling that the market still does not think that economy is on a sound footing and the deflationary pressures are visible.
The bottom line is that though some indicators in 2015 are at similar stage compared to 2004. And the Fed’s statements are showing its comfort level with the improving economy. Whether it will remove the word “patient” in its March meeting or later is not very clear but what is clear is that the case for an interest rate hike in 2015 still remains very weak. Later, we will look at other economic indicators when we revisit this topic.