Economy getting soft, but Fed still tightening up

As expected, the Federal Reserve’s Open Market Committee agreed to raise interest rates another 0.25% today, and in its statement, the Fed indicated that they were doing so because the US economy keeps expanding at a decent, steady pace.

Information received since the Federal Open Market Committee met in May indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year. Job gains have moderated but have been solid, on average, since the beginning of the year, and the unemployment rate has declined. Household spending has picked up in recent months, and business fixed investment has continued to expand. On a 12-month basis, inflation has declined recently and, like the measure excluding food and energy prices, is running somewhat below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee's 2 percent objective over the medium term. Near term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.

In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1 to 1-1/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.

This largely makes sense, but a couple of reports released today indicated an economy that slowed in May. Retail sales disappointed, falling by 0.3%, which was the largest drop in over a year. Some of that is due to lower gas prices, but overall sales were also (barely) down for May.

Inflation sure isn’t acting like the economy is booming either, as the Consumer Price Index fell for the second time in three months. As the Fed alluded to, inflation excluding food and energy over the last 12 months is now at 1.7%, the lowest it’s been in 2 years. And average hourly earnings for workers are also being held in check, as they’re up 2.5% year-over-year, the same as it was in May 2016. A big reason behind any “gain” in real wages in recent months is because of the lower inflation, and even then, 12-month real hourly wages are only up 0.6%.

Regardless, the Fed indicates they think things will continue to get better in the near future and are going to get rid of some of their many Treasury holdings, which also has the effect of tightening money and “taking away the punch bowl” from Wall Street.

The Fed also described its plans to wind down its $4.5 trillion balance sheet, which it expects to begin this year. The program, in which the Fed would gradually reduce its holdings of Treasuries and agency securities, will decrease the Fed’s reinvestment of principal payments. Payments will only be reinvested when they exceed gradually rising caps of $6 billion per month for Treasuries and $4 billion per month for agency debt and MBS.

“The Committee currently anticipates reducing the quantity of supply of reserve balances, over time, to a level appreciably below that seen in recent years but larger than before the financial crisis; the level will reflect the banking system’s demand for reserve balances,” the Fed wrote in an addendum to its statement. The unprecedented size of the Fed’s balance sheet is a lingering a result of the extraordinary easing measures it took in response to the financial crisis.

The greedheads didn’t take kindly to this last part, and stocks dropped in the immediate aftermath of the Fed’s statement (it later recovered to end up near even). But for now, even with the soft data in the early part of 2017, it doesn’t seem like we're so bad that the Fed will stop its plans to wind down the last 9 years we’ve had of easy money, and give some incentive for people to save. We’ll see if that trend continues if we stay at or near full employment in America.