When the Federal Reserve speaks, the collective ears of the financial markets tend to listen. Tasked with promoting the health of the U.S. economy, it drives the nation’s monetary policy by manipulating interest rates and the availability and cost of credit.
After the September meeting, the financial markets absorbed the latest Fed comments reflecting a strengthening U.S. economy and rising interest rates. The Fed indicated the U.S. economy is strong enough to reverse the ultra-low interest rates established in response to the 2007-2009 recession, when it dropped the benchmark fed funds rate to near zero - the gauge which short-term debt and interest rates are often based on. It had also purchased $4.5 trillion in government debt and securities which drove down long-term interest rates.
The key indicator on the health of the U.S. economy is the Gross Domestic Product report, or GDP, released each month by the U.S. Department of Commerce. The report reflects on and revises data for the prior quarter. GDP represents the total dollar value of goods and services produced by the U.S. Robust GDP reflects a demand for goods and services that drives our economy forward.
The latest GDP report shows the U.S. economy grew at an annualized rate of 3.1 percent in the second quarter. This is the fastest pace in over a year and higher than the first quarter rate of just 1.2 percent. Consumer spending, which accounts for two-thirds of all U.S. economic activity, increased by 3.3 percent, its fastest rate since early 2016. In addition, business investment, the big-ticket purchases of buildings and equipment, surged by 6.95 percent in the first half of the year. For 2015 and 2016, the average growth rate was just 0.55 percent.
The first glimpse into third quarter GDP won’t be released until October 27, but initial estimates have been lowered from the extensive economic impact of hurricanes Harvey and Irma. However, recent economic data has been strong enough for the Fed to raise its projected 2017 GDP growth rate from 2.2 percent to 2.4 percent. The projection is below the 3.0 percent rate typical of a healthy economy, but above the current eight-year average of 2.1 percent. Unemployment is expected to remain near a 16-year low of 4.3 percent. The ISM Manufacturing Index, a key indicator of the strength of the U.S. manufacturing sector, just recorded its highest reading in more than thirteen years. Released each month by the Institute for Supply Management, the index reported growth in seventeen of eighteen manufacturing industries.
But the Fed has some daunting challenges to overcome. Annual wage growth has been stuck at a lackluster 2.5 percent for more than two years. Inflation, the year-over-year change in prices for goods and services, has been in a downward spiral since January. At its September meeting, the Fed further lowered its 2017 inflation outlook from 1.7 percent to 1.5 percent. Its 2 percent target rate has not been reached in five years.
The Fed realizes its fortunes rests with the American consumer. Consumer demand for goods and services drives inflation and propels the economy forward. Yet the Fed has already begun raising the short-term fed funds rate. It has implemented four rate hikes since 2015 and is increasingly hawkish for another hike in December, its third this year. It also plans three additional hikes in 2018. This month, the Fed will begin to gradually unwind its massive $4.5 trillion balance sheet, effectively raising the cost of long-term debt for consumers and businesses.
The Fed contends it will continually assess the economic landscape when implementing its short-term and long-term rate hike agenda. But the recent strength of the U.S. economy has emboldened their plans, despite the persistent caveats of low wage growth and inflation. Since their September meeting, the implied odds of a December rate hike have skyrocketed to 81 percent, almost double from a month ago. The Fed has certainly given itself the green light for higher interest rates. Let’s hope America’s consumers and businesses can keep up with their pace.