Between the Lines

Two prominent Fed officials gave major speeches over the last week, and both suggested that the US economy will surge in the second half of this year. Both indicated that this newfound growth in the previously moribund economy means the Fed will raise interest rates soon.

The two Fed officials were Fed Vice-Chairman Stanley Fischer and New York Fed President William Dudley, both of whom are permanent voting members of the Fed Open Market Committee (FOMC) which sets monetary policy. Both want at least another quarter-point hike in the Fed Funds rate range from 0.25%-0.50% to 0.50%-0.75% this year.

The question is, how soon? Some Fedwatchers took their speeches to mean that a rate hike is back on the table for the September 20-21 FOMC meeting. I still don’t think so. The Chicago Mercantile Exchange’s Fed Funds futures don’t think so either. As of yesterday’s close, the odds of a September rate hike stood at only 24%, whereas the odds for a December 14 hike was nearly 54%.

Another question is, why did the #2 and #3 most powerful members of the FOMC choose to make such “hawkish” speeches at this particular time? After all, Fed Chair Janet Yellen will give her own policy speech tomorrow at the annual Jackson Hole, WY gathering of monetary leaders from around the world. Fedwatchers are now wondering if Ms. Yellen will give a similarly hawkish speech (not likely) or stick to her middle-of-the-road, “data-dependent” position on when to hike rates.

Another question is, why are Fischer and Dudley suddenly so bullish on the US economy for the second half of this year? That one is easy to answer. Here it is:

The latest GDPNow reading is for growth of 3.6% in the 3Q. I discussed my views on the GDPNow report at some length last week in Forecasts & Trends. As I indicated, I think the forecast is too optimistic and will be revised lower as we go along, but apparently, Messrs. Fischer and Dudley believe it’s accurate.

Or at least they want us to believe it’s accurate. I hinted at what I’m about to say in last week’s E-Letter, but I want to make the point more forcefully today.

Based on all the economic reports I review each week, I don’t see the economy rebounding to 3.6% GDP in the current quarter. That would be triple the 1.2% we saw in the 2Q. We’ve had two stronger than expected jobs reports recently, but that is hardly enough to justify a 3Q GDP jump to 3.6% from 1.2% in the 2Q and 0.8% in the 1Q.

The only conclusion I can draw is that the Fed is trying to make us believe the economy is stronger than it really is going into the election. While the Fed is supposed to be a non-political entity, keep in mind that the members of the Fed Board of Governors and most members of the FOMC are appointed by the President of the United States.

I think it’s safe to say that these men and women at the Fed want to hang onto their jobs next year and beyond. I think it’s also safe to say that they believe their job security would be much higher with Hillary (the incumbent party) in the White House as opposed to Trump, who has said in the past he thinks Janet Yellen is “highly political.”

A similar overstatement of the economy occurred prior to the 2012 election when projections had to be lowered afterward. In fact, a research paper from the Federal Reserve Bank of San Francisco in early 2015 concluded that:

“Since 2007, Federal Open Market Committee participants have been persistently too optimistic about future U.S. economic growth. Real GDP growth forecasts have typically started high, but then are revised down over time as the incoming data continue to disappoint.”

You may agree or disagree that the Fed is trying to influence the election in favor of the incumbent party that appointed most of the Fed Governors, FOMC members and Janet Yellen herself.

But getting back to the question of a Fed Funds rate hike at the September 20-21 FOMC meeting, I continue to believe it won’t happen. For whatever the reasons, I don’t think the FOMC will raise the rate until after the election.

Even if Fischer and Dudley vote for a rate hike at the September meeting, they will likely only be joined by Esther George, the president of the Kansas City Fed, who has voted for a rate hike several times this year. It will take six votes among the 10 voting members to reach a majority.

If there is going to be a rate hike this year, I continue to believe it will be at the December 13-14 meeting. Let’s see if Janet Yellen says anything tomorrow to make us think otherwise.