Facts, data dependency, and opinions
Today, I listened to Janet Yellen’s Q&S session as I have done every time since she took over the role of Chairman (Chairperson) of the FOMC. As we know, the FOMC conducts monetary policy for the United States. One of their powers is to set the Fed Funds Rate and this has been front and center in the minds of many people. If you have turned on CNBC during U.S. stock market hours during the past several months, it was very likely that you would hear a lot about “liftoff” which means the first Fed Funds increase since 2007. If you listened to CNBC or any other business news channel it has been in such focus. A common topic discussion is will they or won’t they raise rates. If you listened longer, you will have noticed that one “expert” would say they will raise rates and a few minutes later another “expect” would say they won’t raise rates. Then they talk about whether they should or shouldn’t raise rates. We have to remember that all of these things are just opinions. More on opinions later.
If you have watched Janet in her Q&A sessions, you may have noticed that the FOMC has 2 primary objectives: 1) provide conditions for maximum employment, and 2) make sure that inflation is around 2%. Now maximum employment and the inflation are related so it can be a balancing act to achieve maximum employment without inflation in the optimal range. If inflation is too high it is bad and if inflation is too low (deflation if inflation is below zero) it is also bad. If employment is too high then the will be pressure to increase wages which is a cause of inflation. If inflation is too high the economy can become unstable which leads business to cut back which lowers employment. The effects are not immediate so the Fed has to be careful not to overshoot or undershoot in its policy decisions.
So, in essence, what the Fed does is monitor the economic conditions and through its policy decisions steer the economy toward maximum employment and the optimal inflation range. How does the Fed decide what to do? Yellen has been very clear about this and she has been consistent in her explanations. The main thing to remember is that the Fed monitors a large amount of data that is coming in continuously. Based on this data, the FOMC members (there are 12 of them) individually assess the state of the economy. There’s a lot of data coming in that helps them judge the state of economic growth, inflation, wage growth, employment, imports, exports, etc. So there’s not just one thing that they look at. Each member will form an overall opinion about the data and then the group discusses the data. They are data dependent. This means that decisions are not predetermined and FOMC decisions depend on the data available at the time of the meeting. So any “expert” who says the Fed will or should rate rates or lower rates three months from now really nothing about what will happen. Their decision will be based, in part, on what the data between now and the next meeting turns out to be. Since the Fed as consistently said that the employment is pretty much where it is and inflation is still too low, we can say that if employment data indicates that employment is staying the same or continuing to improve and if inflation is heading back up towards 2% then the Fed will likely move higher on rates. One aspect of the economy is imports and exports that are influenced by the exchange rates of the U.S. dollar relative to our trading partners. If Fed raises rates then the dollar will increase in value because more capital will be attracted into USDs because of the better yields. A higher dollar will have a downward pressure on inflation because it will make commodities less expensive in the U.S. that will reduce costs for individuals and businesses in the U.S. Lower inflation is the opposite of what the Fed wants at the moment. A stronger dollar will also lower U.S. exports because it will make U.S. goods more expensive for people whose currency is weakened relative to the USD. While this is a positive for U.S. people who are vacationing overseas, it also lowers U.S. economic growth. A third consequence of a strong USD is that emerging markets such as Brazil are harmed by a stronger dollar at a time when emerging market economies are struggling; if emerging markets (including China) weaken the global economy weakens and the U.S. economy is also affected. Although the exchange rate is not is direct factor in Fed policy (employment and inflation targets are), the Fed does consider this as part of the data that influences growth and thus inflation and employment. Since emerging market economies would suffer from a stronger dollar, the IMF has publicly stated that the Fed should not raise interest rates at this time.
So to summarize, the Fed is data dependent meaning it relies on known facts. Lots of people have opinions about what will happen and what should happen. As an investor, you should examine facts yourself and form your own opinions. I find it helpful to focus primarily on the performance of the handful of companies in which I am invested. I try to take in the facts, analyze the situation, and form my own analysis and likely range of future outcomes for my companies. The macro information plays some role in my analysis but it is minor compared to the information that I collect about my companies and their direct environment. When you understand your companies well, you will become less susceptible to both market volatility and other people’s opinions. Remember, form your own opinions from the facts (just as the Fed makes choices based on the data) and make decisions based on facts and your analysis of the facts.