In her speech from Providence, Rhode Island this Friday, Federal Reserve Chair Janet Yellen said the central bank is on track to raise interest rates this year but will likely proceed cautiously because the job market hasn’t fully healed, inflation is low and growth has again disappointed.
U.S. job growth did rebound in May and the unemployment rate dropped to a near seven-year low of 5.4 percent, suggesting modest but continued positive underlying strength in the economy at the start of the second quarter and helping to keep alive prospects for a Federal Reserve rate hike later this year.
Nonfarm payrolls increased 223,000 as gains in services sector and construction jobs offset weakness in mining, the Labor Department said on Friday. The one-tenth of a percentage point decline in the unemployment rate to its lowest level since May 2008 came even as more people piled into the labor market. However, wage growth was tepid and March payrolls were revised downward.
The Fed expects economic growth to pick up in the months ahead. Her speech came a few hours after the Labor Department reported signs inflation is stabilizing, which should give the central bank more confidence about the economy’s strength.
With many suggesting the market strength of late has been driven by the ultra low rate environment, the more real the prospect for a hike becomes the better a chance the party could be over. But how real is the prospect of a hike in 2015? Or more importantly, in the grand scheme of the markets, how truly impactful would a quarter point increase be?
From a fundamental perspective, a quarter point hike really should have little impact on the markets. However, from a market psychology perspective, it could signal a shift from easing and a hold at ultra low levels to a tightening bias. This may actually be a good thing for the health of the markets in general as it can serve to keep the “froth” in check.
Fed officials have held the rate near zero for more than six years in a financial experiment that investors were originally told would be short-term and temporary in nature. Six years and counting is by no means short term. Now, the Fed sees the rate someday getting to 3.75% or what it considers to be normal in the long run. Their March forecasts showed that even at the end of 2017, they expected the rate to still be below that level.
In fact, on Friday, Yellen stated it could be “several years” before the Fed’s benchmark short-term rate is back to that range. Some believe several years could stretch into a decade. Again, given the unprecedented nature of the financial experiment the North American economy is currently participating in, even the most educated on these matters would just be guessing to provide any realistic timeframe or the eventual outcome.
In the U.S., the consumer-price index rose for the third consecutive month in April, reversing a three-month slide largely associated with falling energy prices. Consumer prices were still lower than they were a year ago after the earlier declines, but underlying inflation outside of the volatile food and energy sectors has stabilized. That could be a sign that broader consumer-price declines have run their course and that the economy, even after a weak first quarter, is not in a deepening slump.
U.S. consumers are spending, but more selectively, which in our minds is not a bad thing. Sectors such as the auto, restaurant and home have been the benefactors. We have seen shares in our top Small-Cap auto-parts manufacturer benefit greatly from this trend over the past 3 years and continue to see strength for the next 12-18 months.