How to read the Fed’s signals

Fundamental economic indicators like the labour market, wages and inflation are sending the Federal Reserve mixed signals, making it difficult for policymakers to make rate decisions, says Benjamin Tal, deputy chief economist of CIBC World Markets.

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“The Fed is confused and confusing,” Tal says. “We’re seeing a situation where the labour market is relatively strong but wages are not rising in any significant way, the inflation rate is not in the sky, and productivity is actually negative. So they’re not sure what economy to look at: the labour market, or the rest?”

The malaise had some market watchers speculating the Federal Reserve would decide to revamp how it monitors the economy — replacing the target inflation rate with another factor, Tal notes.

But in a recent speech, Federal Reserve chair Janet Yellen signaled the central bank wasn’t prepared to go down that road. “Yellen basically said, ‘Forget about that, we’re going to raise interest rates,’” says Tal. Yellen’s tone was a surprise to analysts, who had been expecting a more dovish stance — pushing a rate increase down the road. Instead, Tal says “it was a bit more hawkish than expected.”

Federal Reserve vice-chair Stanley Fischer has said that the U.S. labour market is close to being fully employed. Taken together, Tal says Fischer and Yellen’s remarks indicate a rise in rates is coming soon. He says December is most likely when the Fed will increase its rate by 25 basis points (bringing its key lending rate to 0.5%), and the market is already pricing that into trading. The Fed’s remaining 2016 meetings take place September 21, November 2 and December 4. Tal adds the bank wouldn’t move in November, because of the impact it could have on the U.S. election November 8th, and that September is possible but likely too soon.

“They’ll have to see one or two more good employment numbers,” he says.

Read: Avoid interest rate-sensitive trades

There’s no emergency

As Tal reminds us, “At 25 basis points the Fed funds rate is at an emergency rate, and we are in no emergency whatsoever. Therefore, they’re trying to raise interest rates without really spooking the market too much.”

The Chicago Mercantile Exchange’s FedWatch tool, which expresses the market’s assumptions of a rate change based on the pricing of 30-day Fed Fund futures prices, puts the probability of a September rate increase at less than 25%. That probability rises to more than 50% in December.

Tal has been forecasting a December rate change for months. He says that until recently, the call was too hawkish compared to the rest of the market.

“Many in the market believed that the Fed would not move until the middle of next year, especially after Brexit, but then the market realized that Brexit was nothing more than Y2K […] when it comes to North America,” he says. “The market is now much more relaxed when it comes to the U.S. economy, the global economy, even China. That’s why the market is now willing to discount a 25 basis-point-hike by the Fed by the end of the year. And of course, what Yellen, Fischer, and others are telling us, is basically they’re going to do it.”

Read: Some Fed members worried rate rise will come too late