The policy views that the Federal Reserve’s Federal Open Market Committee expressed on July 30 were quite dovish, in our opinion at BlackRock. But they also showed what appears to be the start of an active debate within the FOMC over the appropriate path for the zero-interest-rate policy. Yet there was also some notable disagreement. A lone dissenting vote at the meeting was cast by Charles Plosser, president of the Federal Reserve Bank of Philadelphia. In a press release, the Fed wrote that he “objected to the guidance indicating that it likely will be appropriate to maintain the current target range for the federal funds rate for [in his words] ‘a considerable time after the asset purchase program ends,’ because such language is time dependent and does not reflect the considerable economic progress that has been made toward the committee’s goals.”
Fellow policy hawk Richard Fisher, the president of the Federal Reserve Bank of Dallas, delivered a speech on July 16 at the University of Southern California’s Annenberg School for Communication and Journalism — subsequently excerpted in the Wall Street Journal on July 27 — that raised serious concerns about policy risk. Fisher’s speech hinted that he may soon represent a second dissenting vote on the FOMC, despite his voting with the majority in late July. Indeed, Fisher suggests that while Fed actions taken during the 2008–’09 financial crisis and subsequent recession likely averted a much worse economic outcome, he has been “increasingly at odds with some of my respected colleagues at the policy table of the Federal Reserve,” and he has said that “the economy is reaching the desired destination faster than we imagined,” placing at risk not only economic recovery and financial stability but also central bank credibility. It is important to recognize that both Fisher and Plosser cease to be voting members of the FOMC in 2015, however, and whereas Federal Reserve Bank of Richmond president Jeffrey Lacker, a noted critic of recent Fed policy, returns to vote that year, the real question is when the FOMC’s centrists may move to lessen policy accommodation because of stronger data.
As we at BlackRock have long argued, labor market recovery has faced significant structural headwinds resulting from job skill mismatches, challenging demographic trends and technological replacement effects. As a result, significant bifurcations have been exacerbated in labor markets, complicating the task for central bankers. For example, short-term unemployment is near a 20-year low, but long-term unemployment (more influenced by structural factors) remains stubbornly elevated. Fascinatingly, when looking at unemployment rate attribution by duration, we see that the cohort of workers unemployed less than five weeks is 18 percent below its 20-year mean, whereas those unemployed 27 weeks and longer is nearly 29 percent higher than that mean. Further, there is growing evidence that tighter short-term labor market conditions are beginning to spur some wage inflation. Of course, there is labor market bifurcation here as well, with most recent wage gains accruing to those with specific skill sets that are deemed valuable, whereas low-skilled workers have seen wages languish.
Beyond wage inflation, we have seen numbers for various inflation indicators solidify during the first half of 2014. These data sets include higher year-over-year (as of June 2014) consumer price index levels of 2.1 percent, producer price index levels of 1.9 percent and personal consumption expenditures index levels of 1.6 percent. These are all considerably higher from the start of 2014. Thus, when it comes to both sides of the Fed’s dual mandate of employment and inflation, there have been indisputable improvements during the past few months. We therefore believe the time to begin normalizing interest rate policy is coming soon. The FOMC may make its first move during the first quarter of 2015 — considerably earlier than markets have anticipated. There are still areas of concern for the recovery, including an anemic residential housing recovery, as Fed vice chair Stanley Fischer pointed out in an August 11 speech. Overall, however, the prevailing trend has been one of improvement.
Although the Kansas City Fed’s annual Jackson Hole symposium this week will focus on structural versus cyclical employment dynamics, the likely consensus will be a continued emphasis on labor slack and, consequently, easy monetary policy. Still, we believe that a framework for policy transition could come within several weeks and that the mid-September FOMC meeting and press conference may provide some signals to this end. In fact, we at BlackRock believe that, in the absence of policy clarity, recent positive economic data such as solid gains in gross domestic product, the employment cost level and jobless claims, as well as tangible improvement in payrolls, the unemployment rate, job openings and wages, are making markets more volatile.
Without greater clarity from the Fed, market participants are making assumptions about what path policy transition might take and are basing their views on historic examples — and subsequent market reactions — which of course are not necessarily analogous to the present situation. We would argue that the ensuing confusion has contributed to higher levels of near-term volatility, changing asset flows and broad-based illiquidity, particularly as it comes alongside geopolitical turmoil in Ukraine and the Middle East. This situation has resulted in reduced willingness to commit capital. The potential for policy overshoot holds implications for an ever-greater bifurcation of income between those who benefit from a wealth effect and those who suffer from higher inflationary costs. Also of concern is the possibility of market bubble formation.
As Fed officials debate the future of rate policy, we hope eventual clarity may serve to stabilize and improve the functioning of markets and might also increase capital investment. We believe the Fed will make it vividly clear that this rate and policy transition will not look anything like the rapid and sizable rate increases of the past. Hence long-end interest rates should rise only modestly, preserving the ability of the housing market to grow and capital investment to accelerate. Moreover, greater normalization of front-end rates, which are less impactful to the present economy than they have been in the past, will ultimately benefit savers and improve the functioning of short-term financing and money markets. We thus suggest that institutional fixed-income investors consider longer-maturity yield-curve investments, such as ten-year and 30-year Treasuries (while being careful about intermediate-term yield curve plays) and municipals, while also maintaining liquidity and dry powder until the Fed articulates its plan. Those reserves should allow patient investors to take advantage of credit market dislocations as they come up. Finally, shorter-end European peripheral debt, local-rate emerging markets and some spread assets in the U.S., such as commercial mortgage-backed securities, still look appealing amid uncertainty.
Rick Rieder is chief investment officer of fundamental fixed income and co-head of Americas fixed income for BlackRock .
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