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Latest from the Fed

Some have been questioning projections made by Janet Yellen on whether or not rates will actually rise in 2015. Apparently, her last speech left investors questioning when the central bank plans to raise short-term interest rates. The Fed is still on track to reduce their monthly bond buying to $45 billion at their meeting this month, but some investors still feel that Yellen gave her audience a vague projection last month.

At the Economic Club of New York last week, Yellen commented, “While monetary-policy discussions naturally begin with a baseline outlook, the path of the economy is uncertain, and effective policy must respond to significant unexpected twists and turns the economy may take”. The vagueness of this statement has left many confused, given that the Fed usually tries to provide concrete information about the outlook of short-term interest rates.

However, now that she has switched to a more mysterious approach, this seems to suggest that slow economic growth, low inflation, and poor measures of unemployment are beginning to slip back into the picture. This contrasts with her statement last month that the Fed may wait six months after the bond-buying ends before raising rates. In regard to the trading markets, investors have reacted relatively calm to the news. Yields on 10-year Treasury notes have remained between 2.5 and 3%. A possible reason that they haven’t moved is because the Fed hasn’t announced any bad news- just somewhat neutral news. As long as a definite position isn’t taken, I don’t think that we should anticipate too much movement.

Another piece of the puzzle related to productivity level- “U.S. output-per-hour worked, a standard measure of productivity, grew just 0.5% in 2013 and appeared to grow slowly again in the first quarter”. The bad thing about slow productivity is that it makes it harder to calculate the amount of slack in the economy level. Slack is a key part of measuring uncertainty, and without the ability to measure of uncertainty it is clearly more difficult to predict the right time to raise interest rates.

In my opinion, I don’t think there’s anything wrong with the projections that Janet Yellen has given. Many keep pressing her to give a concrete date of when to expect rates to rise, but at the end of the day there really are too many factors that control the outcome. Ms. Yellen is not clairvoyant, she’s really doing the best that she can as far as looking into the specific elements that may cause rates to change. We can see this through her decision to drop the unemployment rate target because she believed there were many other forces at hand. In sum, I believe that those doubting Ms. Yellen should sit back and realize that if she were to give a concrete date and then unforeseeable measures caused her to re-adjust her position, the public would be even more displeased. Naysayers need to realize that we have slowly been inching our way out of the recession, the future still looks promising.

Forward Guidance as Stabilizer

We all know that the Fed has been conducting an “unconventional” monetary policy since the end of the recession. The policy consists of bond-buying program and forward guidance program.  A familiar role that Fed’s forward guidance play is to insure investors and market that the Fed will be pursuing low interest rate policy during the period of time described in the guidance statement.

In this post I want to emphasize another role the forward guidance program take in the successful stable economic recovery. By being as transparent as possible about its ongoing monetary policy and future policy, through the forward guidance tool, the Fed officials try to give as much information as possible to market on the future moves in the monetary policy. Why the Fed has been doing this?

The answer relates to rational expectations. According to rational expectation model, economic outcome will depend on what agents, such as investors, firms, and consumers, expect to happen. By providing statements on the future unfolding of monetary policy, the Fed changes and strengthens market’s expectation about the monetary policy. Market then includes their expectations of monetary policy, which are partially created by the forward guidance, in their decision making. When the actual time of policy change comes, the market will react to it little or not at all depending on how their expectation was true. That means, a policy change, in this case, increasing federal funds rate, will receive a little reaction from the market at the time of the event since the market will have foreseen the coming of the policy change. In other words, the market will be considerably stable at the moment of the announcement.

Now, if the Fed hasn’t been pursuing the forward guidance policy for these years, there would have been a much greater monetary policy guessing game before every Fed meeting and more expectations would have been wrong in the absence of the forward guidance. As rational expectation theory would say, the agents whose expectations weren’t met by the policy change would have to make a change in their economic decision after the time of the event. That means there would have been greater stability in the financial market since the Fed’s raise of the interest rate started looking imminent.

In conclusion, the Fed has been stabilizing the markets since the end of the recession partially through its forward guidance program to give clear direction on the market’s expectation of monetary policy. Janet Yellen’s speeches following the Fed’s meeting in March have been to clarify the uncertainty created by the Fed’s meeting regarding the timing of the interest rate rise. That is what Yellen should be doing to ensure that market will not be surprised by the Fed’s move sometime in 2015 and react to it creating instability in the markets.

Yellen at the Economic Club of NY

In Janet Yellen’s speech to the Economic Club of New York on Wednesday, she assured investors that low interest rates would continue and also focused on low inflation and economic slack. This was a follow-up to her meeting in March that left investors with the impression that interest rates would rise in the near future.

During the speech, Ms. Yellen made sure to point out that the economy is an uncertain place, and the Fed cannot lose sight of this as they propose monetary policy. However, she did give a more concrete prediction of when she expects to rise rates. She intends to keep interest rates low until at least the middle of 2015, given that the economic outlook allows the US to maintain low interest rates.

Another main point that Yellen stressed was the inflation rate target. She said that she was more worried about inflation becoming too low rather than too high. Later she added that the Fed’s focus should be on lifting inflation to the 2% target, not holding it down. During the speech, she commented, “The Fed is “well aware” that inflation could shoot above its 2% goal, she said. ‘At present, I rate the chances of this happening as significantly below the chances of inflation persisting below 2%.’” Low inflation is a problem because it signals weak economic demand. Also, not leaving a large enough inflation threshold can lead to deflationary problems in the future. Deflation is detrimental to the economy because it leads to many painful outcomes- the combination of falling prices, consumers’ reduced likelihood of spending, and falling wages depresses the economy and sets it into a deflationary trap. This triggers a vicious circle because rising debt leads to less spending, which leads to further deflation… and repeat.

The problem comes into play when the Fed tries to dictate certain economic issues like long-term unemployment and income inequality. The Fed mentioned that it would like to see wage inflation because this would indicate that slack in the labor market is starting to disappear. Hence, they don’t want discouraged workers to get dropped out of the labor force permanently. Decreasing slack in the labor market will later get job creation back on track. However, the problem is that it’s hard for the central bank to influence these policies. At the end of the day, the central bank is chartered by congress as an independent agency within the government- not to be a policymaker itself. I think that in terms of the trade off between inflation and unemployment, the Fed has more control on the economy through dictating stable inflationary levels. As we have already seen, the Fed has abandoned the unemployment target because there are too broad of measures included that make up this target- many of which the Fed can only indirectly control, if at all. Although the two issues are interrelated- short-term unemployment is relevant for inflation, I believe that the Fed would get the most out of rising inflation back to the 2% target.

(Revised) Citigroup in the Hot Seat

On March 24th, I wrote a post about’s the Fed’s stress test. 29 out of 30 banks passed the test, but the bank that fell below the Fed’s standards was Citigroup. To re-summarize what the stress test actually is- the Fed takes each particular bank’s balance sheet and puts it through a rigorous simulation involving high inflation and severe unemployment. The first portion of the test involves quantitative measures such as leverage ratios, capital levels, and other quantitative measures that test whether the bank can withstand an economic shock. From here, the Fed checks the bank’s capital levels over time. Each bank later proves itself to the Fed through a qualitative test, which measures how the bank would pay dividends and manage capital given that the economy is operating in a recession.

Since the Fed gave its decision on Wednesday, shareholders are not happy because Citi will not be receiving the Fed’s permission to increase dividends and share buybacks. Shareholders reacted by selling Citigroup stock, which is now down about 4%, falling $2.71 to $47.45. Mentioned in WSJ, one portfolio manager at a hedge fund “said he liquidated his Citi holdings after the failed stress test. The investor said he was frustrated because he had had discussions over the past six months with Chief Financial Officer John Gerspach and members of the bank’s investor-relations team, and had been reassured that the bank’s relationship with regulators ‘was improving every single day,’ the investor recalled”.

However, it seems that Citigroup’s capital levels aren’t the actual problem. Their capital levels were actually above the Fed’s minimum threshold of 5% (during the simulated economic recession)- at 6.5% to be exact. The concern was that Citigroup failed the second portion of the test, in which the bank failed to sufficiently prove to the Fed how it would successfully manage capital through a recession. Another reason why the 2014 test was such a big concern was because Citigroup failed to pass the 2012 stress test as well. Even though Citigroup passed the 2013 test, the Fed notified the bank that they needed to refine their risk models and loss estimates. Apparently, Citigroup underestimated its projected losses by about $15 billion in 2013.

Since the 2008 financial crisis, the second portion (qualitative portion) has became much more important. It measures how the bank would actually manage a recession, incorporates past lessons and concerns, takes into account how a bank handles its technology, and also tests how it would handle costly litigation. In my opinion, I think the Fed stepping up their game is a great thing. Even though banks may not like the tightening in regulation, it sends the message that banks need to step up their game as well. For the most part, the Fed is seeing good results. This is evident through 29 out of 30 banks passing the test and according to the WSJ article, banks have more than doubled capital levels since 2009. I think that the market’s perception is what’s most important. Even though Citigroup has ample capital, it needs to convey to its share holders that it can manage this capital throughout a recession. Although the first portion of the stress test is important, the second qualitative portion is what’s practical and relevant for shareholders.

In recent news, the topic of Citigroup failing the Fed’s stress test has become even more controversial. After reading more on the topic, my opinion of the test has also changed. Given that the test was only created in 2009 after the financial crisis, it is still an its nascent stages. Apparently, the portion of the test (qualitative portion that measures banks’ predictions about losses under stressed conditions) that Citigroup failed is considered a “building block” of the test. The Fed is still improving this portion of the test and commented that many other banks have “work to do” in these areas. According to Mr. Corbat, CEO, he believed that the bank had settled with the Fed a 2015 timeline. However, the Fed judged that Citi hadn’t made enough progress on the issues that required more attention. I think that a reason for this may be that Citigroup also failed the stress test in 2012, so the Fed may have kept this in mind while basing their decision. This also brings up the issue of the Fed incidentally failing one bank just to prove to investors that the test is actually valid- given that the stress test is still in its early stages. Also, we’ve seen asymmetric information involving the stress test in 2012 when JP Morgan publicly disclosed its stress test results before the Fed released results for all banks. Thus, their stock went up 7%, other banks were furious, and the Fed attributed the situation to a “miscommunication”. After reading more information about the actual validity of the stress test, Citi seems as if it wasn’t as worse off as the Fed projected it to be. Effectively, we cannot ignore that they still passed the capital level requirement. It seems to me as if this was a scenario where Citigroup received the short end of the deal on a test that still needs work.

What does labor market slack look like?

In her remarks at the Economic Club of New York Wednesday, Janet Yellen focused on the things that the FED would be watching closely going forward.  The chairwoman made it clear she was more concerned with continued low prices then with inflation exceeding the 2% target set by the central bank. However, the FED’s primary focus remains on the labor market.  Fixing this market might take more then just monetary policy.

The Labor market has been characterized as having significant “slack” in it.  This term accurately describes the ability for businesses to add jobs with out having pulling up wages.  An increase in wages could cause inflation, so the FED is closely watching the labor market for signs of tightening.

What makes up this “slack”?  The Federal Reserve Bank of Atlanta publishes what is known as the Labor Market Spider Chart.  The chart provides a comparison of many labor market metrics at various times in one chart.  An image is shown below, but the link is interactive, so I encourage you to check it out.

Levels-Spider-Chart-from-the-Atlanta-Federal-Reserve-961x1024

This chart has a lot of information in it.  Most notably that there are a large amount of people working temporarily and part-time then would be in a healthy labor market.  There is also a dramatic decrease in marginally attached workers, are the discouraged workers who have worked or looked for work in the past year.  Given the other factors in this chart, some of this decrease may be due to workers giving up entirely and dropping out of the labor force, as opposed to actual hires, which are slightly worse then in 2012.

Janet Yellen would also mention that she believes that the economy can reach healthy levels in the employment market by 2016.  If the spider chart can be used to visualize labor market slack, then it can show tightening as well.  The Other parts of the circle need to shift out to their pre-recession levels as well.

There is a slight symmetry to the above graphs.  Hires on the right have to have some effect on job finding rate on the left.  Similarly with job openings and job availability.  Whether the FED alone can institute the policies needed to bring about the needed changes is unclear.  There is a lot of work to do.  The president of the Minneapolis Federal reserve bank, Narayana Kocherlakota has suggested certain fiscal polices that models suggest could result in the needed growth.  However, even if these policies where implemented, 2016 may be a very ambitious goal.

 

(Revised) Fed Drops Unemployment Target

The Fed is still staying on course with the bond buying program. However, some changes have been made to expand the array of indicators used to start raising short-term interest rates, rather than solely focusing on the unemployment rate. Also, Yellen reported at the meeting that the Fed will keep short-term rates lower than usual even after the unemployment and inflation rates return to long-term levels.

In regard to the unemployment rate, the Fed has now decided to drop the connection that it once made to raising the interest rate once the economy has reached the 6.5% unemployment threshold. The Fed plans to use other measures that it believes will represent the situation more accurately, such as the U6 measure (includes marginally attached workers and those working part time but prefer full time work), the share of workers who have been unemployed for six months or more, the rate at which people are quitting jobs, and the share of adults who are holding or seeking jobs.

In terms of interest rates, the Fed plans to keep the short-term rate lower than usual even after the jobless rate and inflation rate return to long term levels. Since the Fed expects a 4% rate as the normal long-run rate, this implies that officials do not expect rates to get back to this level anytime soon. Later actions taken by the Fed were to continue in reduce its bond-buying program to $55 billion. The long-term goal of the program is to hold down long-term interest rates, thus boosting spending, hiring, and growth.

One discrepancy that I noticed in the report was that even though the Fed said it plans to keep rates low well after the Fed returns to the long-run trend, the projections of the actual officials seemed a bit aggressive. More specifically, “Ten of 16 officials saw short-term rates rising to 1% or more by the end of 2015, with four of them right at 1%. Six officials saw rates below 1% by the end of 2015. In December, ten officials saw rates below 1% by the end of 2015. Twelve of 16 officials saw the target fed funds rate rising to 2% or above by the end of 2016, while four officials saw rates staying below 2% by the end of 2016.” In my opinion, I found the projections of these officials in comparison with Yellen’s earlier statements to be contradicting. From Yellen’s report, it seems that the Fed thinks the economy isn’t good enough right now, but will accelerate in the next 12 months- therefore warranting higher interest rates… but the Fed said that it plans to keep rates low “for a considerable time” after the bond buying program ends, given that the program is scheduled to end this fall. However, I anticipate this vagueness has to do with the fact that it depends on the condition of the labor market later this fall. If there were still high unemployment in the labor market and the inflation rate were still running below 2%, this would be good reason to believe that the Fed would hold the interest rate near current levels.

In recent news, the Fed’s minutes released three weeks after the March 18-19 meeting resolved the discrepancy that I addressed in the above paragraph. Reserve officials were concerned at the March meeting that they might have accidentally communicated to the public that they plan to raise interest rates in the near future. While referencing graphs of the Fed officials’ projections, some commented that “this component of the projections could be misconstrued as indicating a move by the committee to a less accommodative reaction function”. In other words, the Fed officials were concerned that a rise in interest rate would lead to a less stimulated economy during a time where exactly the opposite is needed in order to fully recover from the recent recession. “The minutes underscore that Fed officials had not become more impatient to raise rates, a message Ms. Yellen and other members of the Fed’s policy committee have reinforced in public remarks since the meeting.” The Fed’s minutes were well-received. After they were released, many investors experienced stock gains and bond prices increased as well. The minutes also showed that Ms. Yellen had an extra meeting on March 4th to discuss whether and how the Fed should alter the tapering. Meetings like these are unusual, compared to those of her predecessor, Ben Bernanke. Bernanke only held meetings like these during the financial crisis. However, holding meetings like these while not in a recession is beneficial because it shows great leadership and prudence. It proves that Janet Yellen is committed to translating the directions of the Fed very clearly to the public.

The Dangers of Low Volatility

On Monday, I discussed March retail sales and that its strength might be a positive sign economic growth. Today, there is more good news for the U.S. economy. According to the Wall Street Journal, “U.S. industrial production rose in March, moving beyond a lackluster winter and showing potential to gain strength in coming months”. Industrial production gauges the output of U.S. mines, manufacturers, electric and gas utilities. The manufacturing sector is only a fraction of domestic economic activity since the U.S. has transitioned to a service oriented economy. Nonetheless, many economists consider it to be an indicator of future demand.

In fact, economic activity across the United States is picking up steam. According to the Wall Street Journal, “Overall, the latest beige book, which describes economic conditions across the central bank’s 12 districts, pointed to an economy that was getting back on track after growth slowed earlier in the year”. This report, which is two weeks before the Fed’s April policy meeting, will likely have an impact on monetary policy. As the Fed continues to reduce asset purchases, the prospect of rising interest rates becomes more of a reality.

However, the Fed must watch the level of inflation when making its decision about interest rates. Even though economic activity is picking up, inflation is remaining stubbornly low and is a source of concern for the Fed. According to the Wall Street Journal,

Price gains could provide some comfort to Fed policy makers as they debate whether to keep pulling back on their easy-money policies meant to spur growth. Consumer inflation has run below the Fed’s 2% annual target for nearly two years, but price gains have accelerated a bit recently. Some central-bank officials have been concerned that low inflation—which discourages businesses and consumers from spending—could persist and weigh on growth.

Low levels of inflation are being experienced around the world. For example, the Bank of Japan is conducting asset purchases with the sole purpose of creating inflation. For this reason, the Fed can continue tapering at a slow pace as this should help push up inflation.

The problem with low inflation is it might be a symptom of something larger. We are starting to see the United States as well as other countries enter a stable path of growth. In addition, volatility is at very low levels. The last time we had a similar situation was during the Great Moderation. Starting in the mid-1980s, major economic variables such as gross domestic product (GDP) growth began to decline in volatility. In economics, the  “Great Moderation” refers to how stable the business cycle was at that time. We are again seeing that stable path of growth and global inflation, which is coinciding with an approaching of all-time lows again on volatility. However, this situation is easily disturbed. The first time around it masked a bubble in the housing market and that ended in a financial crisis. I am not sure what it is masking this time.

Retail Sales and Producer Prices Go Up

Following three slow months, retail sales jumped 1.1% in March. According to the Wall Street Journal, “Retail sales increased 1.1% last month… the reading was the best monthly gain since September 2012”. Strong retail sales, which are an important piece of U.S. consumer spending, could be an indication of accelerating economic growth. The healthy pickup in consumer spending suggests that weaker spending in recent months was an outlier likely due to severe winter weather.

The automotive component of retail sales led the rise with an increase of 3.1%, which reflects a significant jump in new vehicle sales. According to the Wall Street Journal, “March auto sales, as measured in dollars, rose 3.1% from the prior month. That was the best gain in a year and a half”. Purchasing a new vehicle can be a big investment. Thus, many households make use of auto loans. As a result, the increase in auto sales might also reflect improvements in private credit markets. The availability of credit plays a central role in the booms and busts of business cycles.

In addition to auto sales, other components of retail sales were also solid. According to the Wall Street Journal, “Spending also improved at general merchandise stores, restaurants and nonstore retailers, which includes online shopping… Excluding automotive purchases, sales advanced 0.7% in March, above the forecast 0.4% gain”. Retail sales beat expectations even without including the large contribution by auto sales. I think it is good that the surge in retail sales were well distributed among several different areas rather than being highly concentrated in one (i.e. auto sales). The strong retail sales in March helped restore my confidence in the economic recovery following the weaker data in December and January. The severe winter weather seems to have caused December and January to be outliers among the stronger overall trend in consumer spending.

Retail sales are meaningful component of consumer spending, which is a significant piece of gross domestic product (GDP). According to the Wall Street Journal, “Consumer spending accounts for more than two-thirds of U.S. economic output. As such, expectations for stronger economic growth this year are largely pinned to shoppers’ wallets”. Due to strong retail sales in March, some economists have raised their projections for GDP growth in the second quarter. Consumer spending is a pro-cyclical component of GDP, which means it is positively correlated with GDP. If consumer spending picks up, then we should expect GDP to follow.

Another good sign for the U.S. economy is that producer prices increased 0.5% in March, which might predict a rise in U.S. inflation. According to the Wall Street Journal, “The producer-price index for final demand, which measures changes in the prices businesses receive for their goods and services, rose a seasonally adjusted 0.5% from February”. Although the producer-price index (PPI) is not the Federal Reserve’s preferred measure of inflation, the PPI is still a useful gauge of U.S. inflation. Considering the prolonged period of low inflation, I welcome the increase in the PPI and believe it might be a good sign for the U.S. economy. Furthermore, the 0.5% increase is a noticeable change as it is the largest gain in a single month since January 2010.

Not only does rising prices indicate inflation, it also reflects increasing demand. The increase in demand can also be seen in the strong March retail sales. I think the March employment report, which showed a hiring rebound after the winter slowdown, contributed to the rise in the PPI and the jump in retail sales. When you have a job you are able to spend more and increase your demand, which pushes up prices. The labor market is incredibly important and I completely agree with Janet Yellen’s emphasis on promoting job growth. A healthy labor market is an indispensable component of economic growth.

(Revised) Fed Officials Expect Overshooting in 2016

Following the Fed’s March 18-19 meeting, the policy making committee provided a collection of charts showing the projections of macro economic main variables in the coming years. Before discussing the projections, I should note here a little bit of confusion I have. In the projection file, it states that these projections are “based on FOMC participants’ individual assessments of appropriate monetary policy.” Therefore, these number’s aren’t actually projections as done by someone outside of the Fed, but these are the expected values of these economic variables that could be seen according to Fed officials’ own appropriate policies. 

In other words, when looking at these projections, we should take into consideration that these projections are influenced by each committee member’s policy recommendation.

The recent post on the WSJ touches on how this projection could be misleading the market into expecting that interest rate rise will come sooner than expected. According to the article, some Fed’s policy committee members raised their expectation of interest rates in 2015 and 2016. This could signal market that the Fed policy makers are looking at possible rate increase which is sooner than expected prior to March meeting.

ProjectionFed_March

From the above chart we could see what rate Fed officials are expecting fed funds rate target to be in 2014, 2015, 2016 and long-run. In 2014, according to the chart, we see that the policymakers almost unanimously expect the fed funds rate target be at the current level of 0 to 0.25 percent target. In 2015 and 2016, the averages of the Fed officials’ expected fed funds rate are around 1 percent and 2.5 percent, respectively. The policy makers expect the rate to be around 4 percent in the long-run. This rate is slightly lower than the historical average of the fed funds rate target since 1990, which is 4.2 percent. In general, the committee members expect to have similar fed funds rate target that it has had since 1990.

Note that, the expected fed funds rate target is still lower than long-run expected rate of 4 percent at around 2.5 percent in 2016. Hence, it is plausible that somewhat easy monetary policy will be taking place until 2016. But we should always remember that low interest rate doesn’t always mean expansionary monetary policy as Milton Friedman put it, “After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

The surprise of the projection comes when we look at another chart which was included in the same projection report. The following chart shows how the committee members expect the unemployment rate to be under appropriate policy in coming years and in the long-run.

ProjectionFed_MarchUn

 The central tendency among the policy makers regarding the expected unemployment rate in 2016 is along with the long-run projection: at 5.2-5.6 percent.

So, what can we conclude about the Fed’s future policy from these two charts?

The Fed policy makers are believing (or seems to be) that under appropriate policy, the Fed will be pursuing expansionary policy even after the unemployment rate reaches the long-waited long-run average. In other words, the Fed policy makers think overshooting the unemployment rate is a viable option for the Fed policy in coming years. This is along the line with the worry about low inflation in coming years. Another chart in the projection shows how the policy makers expect inflation to be in coming years.FedINflation

 As we see from the chart that central tendency among the officials regarding the expected inflation in 2016 is below the Fed’s target of 2 percent inflation. It is kinda counter-intuitive; they target 2 percent, but expect it to be below it. Or are they really targeting 2 percent?

Then, given the the below target inflation rate, the Fed officials shouldn’t be worried about their fed funds rate target expectation below the long-run expectation.

From the Fed officials’ projection, we can conclude that the Fed will be still operating somewhat stimulus policy in 2016 relative to their long-run policy. if we assume these projections are made with rational expectation

Inflection Point for U.S. Economy: And Perhaps the World

The United States economy seems to be at an inflection point in which growth will either accelerate above the trend or remain below. The March Employment report had some very positive signs, which showed that more people are finding jobs. According to the Wall Street Journal, “All of the gains came from private companies, which added 192,000 jobs. The March gain means the private sector has regained all the positions lost in the recession”. Although the 192,000 jobs added was just below forecasts, I think it is a strong number that proves the December and January employment reports were outliers that were negatively impacted by severe winter weather. The recovery has been painfully slow in the labor market, but the March employment report was a significant step in the right direction. The better level of hiring, as evidenced by the March employment report, will hopefully give a boost to consumer confidence and in turn support consumption expenditures.

According to Ray Dalio, credit expansion and credit contraction essentially determine booms and busts in economic business cycles. Following many years of expansion, the credit market collapsed in the recent financial crisis. Thus, the health of private credit markets is central to the current inflection point of the U.S. economy.

fredgraph_credit

As seen above, the year over year percent change in private credit has recently turned in the right direction. If credit markets continue to strengthen, households will be able to take on more leverage. An improvement in private credit conditions is indispensable to supporting the positive signs in the March employment report.

If the March employment report was so lovely and credit conditions are improving, then why the recent dip in financial markets? I believe changing expectations about future interest rates played a significant role. Expectations about interest rate increases are mid-2015 (i.e. 6 months following the end of quantitative easing) and there are concerns surrounding what the impact will be on each sector of the U.S. economy. On the one hand, financial stocks moved up on the news as they stand to earn more interest revenue from loans. On the other hand, sectors sensitive to interest rates (ex. Housing) will likely suffer when rates move up at first. For example, higher interest rates decrease affordability in the housing market and could potentially lead to decreased residential investment. A key rate to watch is the ten-year Treasury yield, which is usually considered the risk-free rate for long-term debt and is thus intertwined with many other rates.

fredgraph_10yr

The yield on the ten-year Treasury has tested 3%, but has remained below it. I believe it is only a matter of time before the 3% level is breached. As mid-2015 approaches, expectations about future rates will need to be fully priced in. As a result, a first test for the inflection point will be whether sectors that are sensitive to interest rates can handle higher rates. If all of this goes smoothly, then the United States economy could reach escape velocity and grow above the cyclical trend of 2.5%. Wonderful! Not so fast… According to the Wall Street Journal,

If the U.S. grows a half-percentage point faster than expected, it would force the Federal Reserve to raise interest rates at a quicker clip. That would boost borrowing costs for emerging markets more than many governments and investors planned, raising serious questions about the ability of countries, households and corporations to pay off their debts.

Although I am hoping for stronger economic growth in the United States, I was unaware that it might cause problems for the rest of the world. To be clear, the IMF is expecting the U.S. economy to expand at 2.8% this year and 3% in 2015. I am not sure how likely the U.S. is to grow above these levels, but I am very pleased by the signs in the labor and credit markets. Hypothetically, if U.S. economic growth takes off, then the Fed must respond quickly and effectively with higher rates despite a negative impact on the rest of the world. As the Fed demonstrated during the major sell off in emerging markets this year, the Fed’s mandate is the U.S. economy and so it must keep its focus here.