Should We Believe The 'Transitory' Story?

George Yacik - Contributor - Fed & Interest Rates

The bond market may have stopped listening to the Federal Reserve, but that doesn't mean we shouldn't know what the voting members of its monetary policy committee are thinking. What's clear is that they're not as united as they were at their last meeting just two weeks ago, when they voted nearly unanimously to raise interest rates by 25 basis points, with only Minneapolis Fed President Neel Kashkari voting against.

Now, no sooner was the vote cast, but it appears that it at least one member, maybe two, have misgivings about voting for the increase. At the very least, they're not as much in a hurry to raise rates again soon, if not until the end of this year, if not even later.

Still, as you would expect – or hope for – in a body of intelligent people, there's a strong difference of opinion on what the Fed should do next as it concerns interest rates.

On the dovish side, the presidents of the regional Fed banks in Chicago and Dallas seem to have joined Kashkari in being skeptical about raising rates when economic reports, especially inflation, simply don't merit doing so. On the hawkish side, the presidents of the New York and Cleveland Feds are siding with Fed Chair Janet Yellen's view that the current economic malaise is merely "transitory" and that there's no good reason for the Fed to pull back from its plan to raise rates at least one more time this year.

Charles Evans, the head of the Chicago Fed, told the Wall Street Journal that the central bank "could wait until the end of the year" before raising rates again due to weak inflation reports. In a possible swipe at his Fed colleagues, Dallas Fed president Robert Kaplan said, "I'd like to see now a confirmation in the data that the recent weakness in March, and to some extent April and May, was transitory," he said. "We should be very careful about raising rates, and we should do it patiently and carefully. I'm going to need to see improvement" in inflation before voting for another rate hike.

St. Louis Fed president James Bullard, who doesn't have a vote this year, is also skeptical about how "transitory" the recent weakness is. "The U.S. economy remains in a low-growth, low-inflation, low-interest-rate regime," he said. "The current level of the U.S. policy rate is likely to be appropriate for this regime over the forecast horizon."

On the other side, there are at least three voters who are sticking to the transitory story. "Inflation is on this gradual upwards path that we've been projecting for a while," Cleveland Fed president Loretta Mester said. "We got a couple of weak reports but fundamentally it doesn't look like demand is falling out."

And William Dudley, president of the New York Fed, said "If the labor market continues to tighten, wages will gradually pick up, and with that we'll see inflation get back to 2%," he said.

Dudley displayed some awfully strange reasoning in arguing for a continued aggressive policy of raising interest rates. Rather than the recent weak economic news arguing for holding back on future rate hikes, he said they actually present an "additional impetus" for raising them.

"Monetary policymakers need to take the evolution of financial conditions into consideration," Dudley said. "When financial conditions ease, as has been the case recently, this can provide additional impetus for the decision to continue to remove monetary policy accommodation."

Then, of course, we have the Fed chair herself, whose last public pronouncement on the issue came at her press conference following the June 13-14 meeting. "It's important not to overreact to a few readings and data on inflation can be noisy," Yellen said famously.

So, what's the upshot of all this for the bond market?

Since the middle of March, as the Fed has tightened monetary policy, yields on benchmark 10-year Treasury notes have fallen more than 40 basis points, the exact opposite of what you would expect them to do if all they had to act on was Fed pronouncements. But since investors and traders operate in the real world, where economic growth and inflation are weak, rates have come down.

If one were of a contrarian bent, one could reasonably argue that if the Fed does decide to move in a more dovish direction and keep rates steady the rest of this year, then the bond market may again take the opposite tack and sell off, meaning higher yields. I think that's the most likely thing to happen.

The Fed doesn't meet again until the end of July and then not for two more months after that. A lot may happen in the meantime.

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George Yacik Contributor - Fed & Interest Rates

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from for their opinion.