Why You Shouldn't Rely on the Fed Leaving Rates 'Lower for Longer'

After all the shouting about interest-rate hikes, are the Federal Reserve and the markets all the way back to "lower for longer?"

On the surface, it sure looks that way. As the Fed prepares for a monetary policy committee meeting this week, at which it was widely expected to raise short-term rates to as high as 0.75% as recently as two weeks ago, expectations about the pace of increases are once  again sliding. That's the upshot of a Morgan Stanley report, at least, arguing that the Fed's likeliest play now is to raise rates only three times (not four or more) in each of the next two years, leaving rates no higher than 3% at the cyclical peak.

But it's a little more complicated than that. For each one of the few markers that point toward a stumbling expansion, another points to the idea that the economy is doing about as well as it has for the past several years, in which annual economic growth has run about 2.4%. Taken together, they're an argument that the market is making way too much of a May jobs report that showed only 38,000 new jobs -- or 73,000 if you look past the since-settled strike by 35,000 workers at Verizon Communications who have returned to work already.

First of all, there is the wonky-but-important matter of how the government mangles first-quarter growth estimates pretty much every year, and the fact that late-breaking data are still pushing estimates of first-quarter 2016 growth higher. Barclays' latest estimate of first-quarter growth is that the economy expanded at a 1.2% annual rate using the government's methodology, up from the government's 0.5% initial estimate. From there, it gets a little squishy, but LPL Financial economic strategist John Canally's rule of thumb is to add about 0.8% to the first-quarter numbers, which gets you to 2.1% first-quarter growth.

The Commerce Department's problem with seasonal-adjustment methodology pushes some growth into the second quarter, so the smart approach is to average first-quarter and second-quarter numbers, Canally said earlier this month. Estimates for the second quarter range from about 2.5% from the Atlanta Federal Reserve Bank to 2.7% at Barclays. Follow Canally's advice, and growth is running at about its average for the past couple of years, which suggests Fed policy won't deviate much from prior expectations.

That view is bolstered by a look at labor-market data such as jobless claims, which show no pickup, and wage growth, which show a slight one. Those figures and a backdrop of nearly 5.8 million U.S. job openings suggests the market will keep nudging wages higher. Consumers, meanwhile, are showing no sign of panic: Retail sales, which rose 1.3% in April, are expected to climb 0.4% when May results arrive this week (less acceleration in gasoline prices drives the slower growth rate).

Housing sales are firm, and so are vehicle sales. If people are worried, it's not showing up in major purchase decisions. And between higher wages, low inflation and cheaper gasoline, real wages are up about 2% in the past year.

Finally, if the job market were really slowing down, it's not very likely Microsoft (MSFT) would spend $26.2 billion to buy LinkedIn (LNKD) , which is all about job hunting. After all, serial overpayer Steve Ballmer isn't Microsoft's CEO any more.

On top of that, recent inflation is moving toward the Fed's 2% target range pretty much as Janet Yellen & Co. have been predicting all along, so the pressure the Fed feels to rein in an historic stretch of extraordinarily easy money hasn't gone away.

All of this argues that investors shouldn't get too comfortable with a lower-for-longer outlook: Nothing Yellen said in her June 6 speech to the Philadelphia World Affairs Council backs it up much.

"Although the economy recently has been affected by a mix of countervailing forces, I see good reasons to expect that the positive forces supporting employment growth and higher inflation will continue to outweigh the negative ones," the Fed chair said in her understated way.

The potential weak spot is capital spending, which affects companies from Boeing (BA) to Caterpillar (CAT) . But politicians from Republican House Speaker Paul Ryan to presumptive Democratic presidential nominee Hillary Clinton, who's sporting a 4-point poll lead over GOP rival Donald Trump, are calling for an investment-boosting increase in federal infrastructure spending next year.

This week, look for the Fed to stand pat. Watch the language in committee's statement for signs of whether other members disagree with Yellen's cautiously expressed view that May's jobs report was an aberration, or for oblique signals that rates will still rise by September.

But mostly, watch this week's reports on retail sales, on Tuesday; industrial production, on Wednesday; and new-home construction, on Friday. They'll carry the real message. And most likely, it's that little has changed.

See full coverage on the Fed's upcoming interest-rate decisions.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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