Why The Fed May Raise Rates Soon (What Big Sister Is Watching!)

There was an excellent Bloomberg article entitled “Yellen Is Watching These Four Indicators for Signals on When to Raise Rates.”

Forget the Federal Open Market Committee’s pledge to be “patient” in raising rates from near zero. Forget “considerable time” and unemployment “thresholds.”

The new buzzword at the Federal Reserve is “reasonably confident.”

That’s the phrase Chair Janet Yellen and her colleagues at the Fed used in the statement this week to describe their need to feel pretty sure that inflation is on the way back to their 2 percent target before liftoff.

In her press conference on March 18, Yellen laid out the markers for what “reasonably confident” means. While “I don’t have a mechanical answer for you,” there are four targets that matter.

1. Jobs, jobs, jobs

Labor markets need to continue to improve. “A stronger labor market with less labor market slack is one factor that would tend to, certainly for me, increase my confidence,” Yellen said.

One key measure of slack is the unemployment rate, which was 5.5 percent in February. The FOMC this month lowered its estimate of longer-term unemployment to 5-5.2 percent. That is a kind of speed limit at which further declines would push up inflation as the stronger hiring spurs faster wage gains. So the labor market has a little further to run before officials expect to see wages rise.

2. Core inflation

Inflation without the food and energy components needs to stabilize. “We expect inflation to remain quite low because of the depressing influence of energy price declines and the dollar,” Yellen went on. “We will be looking at the inflation data carefully” to discern what’s happening beyond those short-term influences.

In other words, a stabilization or rise in core prices, excluding food and energy, might have more weight than the actual headline price data.

3. Wage growth

Wages need to break out of their slump. “We will be looking at wage growth” as a signal of inflation though “I wouldn’t say either that that is a precondition to raising rates.”

There is plenty of anecdotal evidence from the likes of Target Corp. and Wal-Mart Stores Inc., for example, that wages are edging higher. Yet there’s not much support in the data. Average hourly earnings rose just 2 percent over the past year through February. That is in line with the average since the recession ended in June 2009.

4. Inflation expectations

What households and investors expect inflation to be in the future has to rise a bit. “We’ll be watching inflation expectations.” For one thing, “market-based measures” of expectations are too low. “If they were to move up over time, that would probably serve to increase my confidence.”

The measure that looks at inflation expectations five years from now fell as low as 1.75 percent in January. A move back to 2 percent would add to confidence.

But there is a fifth consideration: bank net interest margins. Net interest margin (NIM) is a measure of the difference between the interest income generated by banks or other financial institutions and the amount of interest paid out to their lenders (for example, deposits), relative to the amount of their (interest-earning) assets.

Let’s use JP Morgan Chase (JPMC) as an example. Their Net Interest Margin (NIM) like that of other banks has been in a nosedive.

And if we look at JPMC’s annual report for 2014, you can see that a +100/+200 parallel shift in the yield curve could add billions to their value.

So while The Fed is lowering their expectations of when to hit targets for a rate increase, there is also pressure from lenders to increase interest rates. Particularly if The Fed can STEEPEN the yield curve slope (perhaps through Operation Twisted).

Big Sister is watching … key economic indicators (and bank net interest margins)!