Last call for higher interest rates in 2016

After the Fed's September meeting, the board released its third policy statement of the year. Little had changed from the prior release, save for one new, conspicuous sentence:

“The committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives.”

It's been well documented how badly the U.S. Federal Reserve (Fed) wants to normalize monetary policy, and equally well documented how unfavorable the macro environment has been in offering the Fed a good reason to do so. The situation in Europe following June's Brexit vote remains one source of concern, as it remains to be seen whether the United Kingdom will actually make good on its vote to leave the EU and whether other countries will seek to follow suit. In the United States, economic data remains mixed: Jobs gains, while generally encouraging, have only reached the benchmark 200,000 level three times in 2016.¹ Inflation, the other leg of the Fed's dual mandate, has remained subdued for much of the past five years.

Outside of the macroeconomic constraints the Fed is facing, there are technical boundaries as well. As of the end of September, the effective federal funds rate—the real-world rate banks charge each other based on the Fed's target lending rate—was 0.40%, while the yield on the two-year U.S. Treasury was 0.77%.² Historically, a spread of 100 basis points (bps) to 125bps between the effective federal funds rate and the two-year Treasury suggests that the market is expecting higher short-term rates. But with a spread today of less than 40bps, there isn't much room for the Fed to raise rates without risking inverting the yield curve.

By way of background, under normal circumstances, bonds with longer maturities offer higher yields than bonds with shorter maturities in order to compensate investors for the incremental risk associated with that longer holding period. When short-term debt (U.S. Treasury bills, for example) offers higher yields than longer-dated debt (such as U.S. Treasury notes with maturities of 2 to 10 years), watch out—it's a sign that something isn't right with the economy and the markets. It's also a fairly reliable indicator of a pending recession: The last time the federal funds rate was meaningfully higher than the yield on the one-year Treasury was 2008, and that was not a year the Fed remembers fondly.

As it stands, the yield curve is now flatter than it's been at any point in the past four years. If the Fed were to increase the target federal funds rate by another 25bps in December—for a stated target range of 0.50% to 0.75%—other short-term rates would normally increase, too, and the result might be about as flat a curve the Fed is willing to risk.

Beyond its policy concerns, the Fed also wants to maintain its status as being apolitical; the last thing the board wants is to become viewed as the monetary policy wing of either political party. The bottom line is that, whatever happens in the November election, the Fed's December meeting is its last chance during this administration to make good on its desire to continue normalizing interest rates, and if the Fed decides to wait until 2017, there are no guarantees that the environment will be any more hospitable. If the economy continues to be good enough, December may well be the Fed's last best chance to raise rates for the foreseeable future.

1 ADP National Employment Report, 2016. 2 U.S. Federal Reserve, U.S. Department of the Treasury, 2016.