The Federal Reserve has not only moved the goal posts, they have exchanged the football for a badminton birdie. Under the Bernanke regime, several benchmarks were offered as significant to determining the next cycle of rising interest rates.  However, after the recent confab of world central bankers in Jackson Hole, not only have these benchmarks changed, some important ones have been totally discarded.  The two big changes are 1) what constitutes the unemployment rate and 2) tolerable inflation.

As interest rates were kept low, everyone knew that someday rates would increase, and justification for low rates were in consideration of an employment rate of 5.5% and higher and inflation at or below 2.0% annually.

As these benchmarks are close to being realized and with the Fed apparently not willing to begin the next cycle of interest rate movements, the widely used unemployment rate has been replaced by a “basket” of 19 labor measures.   Inflation rates have crept up to over the 2.0 target, but just not for the most recent 12-month period.

The problem is the unemployment rate was 6.2% in July and 3-month annualized inflation numbers stand at 2.8%.

The new unemployment benchmark is called the Labor Market Conditions Index (LMCI) and includes items such as the number of individuals quitting their job and a ratio of “jobs plentiful vs hard to get”.  This change makes Fed policy goals much more opaque, rather than their stated goal of being more transparent. 

Inflation has been creeping up over the past several quarters.  First Trust Advisors commentary recaps the most recent numbers:

“Consumer prices continued to move higher in July, though only at the tepid 0.1% pace the consensus expected. Although consumer prices are up a moderate 2% from a year ago, the year-over-year number masks an acceleration. The CPI is up at a 2.5% annual rate in the past six months and up at a 2.8% rate in the past three months. Since the start of 2014, consumer prices are up 2.4% at an annual rate versus the 1.2% pace in first seven months of 2013.”

Troublesome is July’s 3.6% annualized increase in housing, called the Owners’ Equivalent Rent, which comprises about 25% of the CPI, and Energy prices’ upward trend.  According to First Trust Advisors, the preferred CPI numbers used by the Fed, called the PCE deflator, would show a 1.6% rise in prices year-over-year, and is precariously close to its 2.0% target. 

However, it seems the Fed will once again repeat history by being behind the curve, so to speak.  It appears the Feds usually keeps rates too high for too long at the top of the business cycle and correspondingly keeps rates too low for too long at the bottom of the cycle. We are currently at the bottom of this rate cycle.

The Fed appears to be taking on the role of developing both monetary policy and fiscal policy.  The baseline reason for sluggish economic growth is not high borrowing costs but rather crippling and increasing government regulations, along with redistribution using higher taxes and spending, and the increase of employment costs associated with higher mandated employee benefits.  Low interest rates, at this point in the expansion, will not offset structural changes in costs associated with conducting business in the US.  In an attempt to increase factory and asset utilization, the Fed will keep rates lower than the underlying economic data should indicate.

The head of the Atlanta Federal Reserve Bank, Mr. Dennis Lockhart, recently stated the risk of being behind the curve,

“If we were early and then saw a weakening of the economy, I think it could be very damaging to reverse course in short order. So to me it seems more sensible to run the risks related to being a little late than the risks related to being a little too early."

What is the risk of being too late? It could be unwelcome inflationary pressures that look like they are going to be persistent.  I find it low probability, frankly. We still are below the target and even with the firming we saw earlier this year we have seen a softening. So we still have some room just to get close to target.”

In another recent interview, Mr. Lockhart said he is a "mid-2015-er," meaning that he expects economic  data “will probably come together" in the middle of next year allowing the Fed to begin to raise rates. However, Lockhart indicated he would support earlier action if economic data consistently exceeds Fed expectations.

More information can be found in an article in the WSJ interviewing Mr. Lockhart, and in the Fed Notes White Paper explaining LMCI (and a bit boring):

Fed’s Lockhart: Unemployment Rate Overstates Degree of Job Market Progress

Assessing the Change in Labor Market Conditions

What does this mean for investors?  The outcome is that while rates will increase next year, do not look for constrictive “tight” money conditions anytime soon.   Continued lax monetary policy seems to be the medium-term goal.  The offset of this will be higher inflation down the road that will eventually force the Fed’s hand.  “Higher” inflation may be in the 3% to 4% range, not disastrous by historic standards, but higher nonetheless.

 By the time higher inflation becomes a topic of mainstream media, most inflation-focused opportunities should have moved higher.  Now would be the time to review investments that may benefit or that historically move higher when there is an uptick in inflation.