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December Rate Hike Still a Toss Up

October’s Fed statement leaves the door open for a rate increase, but slack in the economy, low inflation, and global worries could very well stay the bank’s hand, says Morningstar’s Roland Czerniawski.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. As expected, the Federal Reserve held rates steady in October but left the door open for a December increase. I'm joined today by Roland Czerniawski--he's a markets research analyst here at Morningstar. We're going to get his take on the Fed statement and what he thinks the possibility of a rate increase in December is.

Roland, thanks for joining me.

Roland Czerniawski: Great to be here.

Glaser: Let's start with the statement. As expected, they didn't change rates; but did we learn anything new from this statement versus just a month ago?

Czerniawski: I think there certainly has been new information released in the minutes today. One of the big changes was the fact that they dropped global uncertainty as one of the issues why they wouldn't raise rates. They said that they will continue to monitor this issue closely, but they no longer said that this is something that will hold them back from raising rates. Another important piece of information that we learned today was that they have actually acknowledged that the employment market might have been a little bit slower than they expected, especially given the September jobs report. But at the same time, other sectors of the economy--such as housing, business investment, and consumer spending--have been actually growing at a solid rate, which is an upgrade of language compared with just "moderate" rates in the last minutes.

Glaser: Let's look at some of that data, then--particularly the jobs market because that's a key focus for them. Do you still see a lot of slack there? Is there a lot of room for improvement?

Czerniawski: I think the last employment report was definitely disappointing at 142,000 jobs, and Fed has acknowledged that in the minutes. They seem to downplay that a little bit with acknowledging also that other sectors of the economy are doing really well. But nonetheless, I think there is still some slack in the economy. This recovery has been really slow, and we've gone a long way since the beginning of it. The economy is much stronger now than it was five or six years ago. But I think that there is some slack left in the economy, and the Fed has actually acknowledged that.

They also say that underutilization of labor, specifically, is diminishing, which is good news, and that it will take some time before we get to that optimal point in the economy where all the resources are perfectly utilized. That's what's called the output gap; currently the output gap is 2%. That means that we are not using all the resources that we could in an ideal scenario. A lot of it comes from the labor market. That output gap is expected to close sometime in 2017. So, until then, I think that there is some room for improvement in the labor market and the economy, in general. When we reach that point, I think we could see some inflationary pressures begin to emerge.

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Glaser: That leads into the next question about the Fed. It's obviously focused on inflation. They said they are waiting for signs inflation will be moving to that 2% target in the medium term. With that slack, is that really reasonable right now? What do they have to see to be confident that inflation is going to come back?

Czerniawski: I think it's still possible to reach the target before closing the gap. With that being said, core PCE, which is a measure that the Fed tracks, has been relatively low at 1.3%. And it actually has been moving away from their target since 2012, edging down consistently. So, I think this has been a measure that hasn't supported their statement that inflation will return to its target. But a lot of their focus is on the inflation expectations and, according to their calculations and their surveys, it seems to point to the fact that inflation should return to its target in the medium term. So, I think they are downplaying the actual data a little bit and focusing on the expectations instead. With that being said, they would like to at least see the core PCE, the actual data, move toward that target or begin to move toward that target. That would definitely give them some additional confidence as far as the situation on inflation.

Glaser: Outside of the U.S., are they at all concerned--or do you think they will be concerned--about the impact of a rate hike on developed markets and on emerging markets? Is that also weighing on them still?

Czerniawski: I think to a certain extent that is still an issue. As I said, they dropped the language about global uncertainty having negative effects on the U.S. economy and U.S. inflation. But with that being said, they mentioned that they're continuing to monitor this issue closely, and they are aware of the risks that are involved when the United States begins to raise rates while other countries are still easing. That has an effect on the dollar, and it has an effect on import/export prices. One of the reasons for low inflation has been low energy, but also low non-energy-related import prices, and the Fed has acknowledged that as well. So, I think they have a difficult decision to make, and certainly the December meeting won't be an easy one.

Glaser: Looking at that meeting, what do you think the probabilities of a rate hike are? What's the market predicting as well?

Czerniawski: The market was pricing the probability of a rate hike in December at about 38%. After the meeting, this has changed a little bit. Now it's at about 45%. So, the probability of a December hike has risen after the minutes, and I think this is due to the fact that global-uncertainty reasons have been dropped and that the Fed has acknowledged some improvements in certain sectors of the economy. But with that being said, I think that, overall, it's a very close call. It's about 50-50. And considering the disappointing jobs report last month, we will have to actually see some data that would support the idea that the economy is strong enough to handle a hike and maybe prove that this September report was just a one-off. So, I think there's a 50-50 chance of a rate hike right now; but given today's data, it may be even less than that.

Glaser: A possibility, then, but not a done deal.

Czerniawski: Exactly.

Glaser: Roland, I certainly appreciate your analysis today.

Czerniawski: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.