Following Fed Chair Janet Yellen’s monetary policy testimony in mid-July, the odds of a September rate hike seemed about even. That doesn’t mean that the Fed’s decision would be a toss-up at the time of the meeting. When the September 16-17 policy meeting rolls around, it should be pretty clear what the Fed will do (or not do). Rather, that policy outlook reflected the uncertainty in the economic data that would arrive between now and the September FOMC meeting. However, just two weeks later, the evidence is pointing to a likely delay.
Real GDP rose at a 2.3% annual rate in the advance estimate for 1Q15. No surprise, consumer spending was strong (led by strength in durables) and business fixed investment was soft (partly reflecting a further drop in energy exploration). The Bureau of Economic Analysis introduced a new aggregate: final sales to domestic purchasers (a 2.5% pace in 2Q15). This is simply GDP less net exports, the change in inventories, and government. These components are normally noisy, but did not make much of a contribution either way in the second quarter.
Annual benchmark revisions reduced the reported pace of growth over the last few years, with most of that concentrated in 2013 (coincidentally, that was when tighter fiscal policy subtracted about 1.5 percentage points from growth). As a result, GDP is currently 2.9% below the Congressional Budget Office’s estimate of potential GDP. The CBO’s estimate of potential GDP is a bit fuzzy. However, GDP is still over 11% below the trend that was in place before the recession. The output gap (the difference between GDP and potential GDP) is being reduced, but it is still relatively high – more importantly, higher than it appeared to be before the GDP revisions.
Clearly, the Fed is not going to rely solely on estimates of the output gap in setting policy. The focus has been on the underutilization of labor resources. While the unemployment rate has come down, improvement has been exaggerated due to low labor force participation. There are other signs that the slack in the job market is being reduced, and we should see further evidence in Friday’s employment figures for July. However, a considerable amount of slack remains. This slack is reflected in labor compensation. The Employment Cost Index is the best measure (although one still has to factor in labor productivity growth to calculate the inflationary impact). The ECI popped higher in the first quarter, but the second quarter gain was mild, bringing the year-over-year gain back below 2%. A year ago, Fed Chair Yellen highlighted the “lackluster” growth in labor compensation as evidence of labor market slack. The pace still appears to be relatively lackluster.
The ECI data should put the odds of a September hike well below 50%. Still, the more important issue is the pace of tightening over the next few years. In June, the Fed inadvertently posted staff projections on its website. The Fed staff forecasted a 1.26% federal funds target rate average for 4Q16 and a 2.12% in 4Q17 – in other words, “gradual.”
In her monetary policy testimony to Congress, Fed Chair Janet Yellen made it clear that the central bank remains on track to begin raising short-term interest rates later this year. However, she gave herself an out, indicating that Federal Reserve officials’ projections of the federal funds rate are “based on the anticipated path of the economy, not statements of intent to raise rates at any particular time.” Moreover, she continued to imply that people should stop worrying about the timing of the initial move and focus on the projected path over the next couple of years, which she expects to be gradual. None of this has helped ease the market’s anxieties about the Fed’s timing.
The unemployment rate hit 5.3% in June, but that overstates the improvement in the job market. Fed Chair Yellen has highlighted a number of gauges, including hiring and quit rates. The number of people working involuntarily part-time has been falling, but is still higher than normal. Yellen: “while labor market conditions have improved substantially, they are, in the FOMC's judgment, not yet consistent with maximum employment.”
The inflation outlook is an important factor in the Fed’s decision to begin raising rates. For some time, policymakers have indicated that they need to be “reasonably confident” that inflation will move toward the Fed’s 2% goal. Inflation was pushed lower in the first half of the year due to lower oil prices and a stronger dollar. After falling sharply into the early part of the year, the dollar has been essentially range-bound since mid-March – but that could change. In the short term, exchange rates largely reflect central bank policies. The Fed is considering when to tighten. The ECB has undertaken quantitative easing and Mario Draghi, the central bank’s president, has signaled no intention of curtailing asset purchase plans (which are set to continue to September 2016). The Bank of Canada lowered rates last week for the second time this year. The Fed anticipates that the decline in oil prices will run its course, relieving downward pressure on consumer price inflation in the months ahead. However, crude oil prices have turned down again and longer-term futures contracts (which, granted, aren’t a great predictor of spot prices) point to a sustained period of low oil prices. Low inflation may last longer than the Fed expects.
The federal funds futures reflect a lower rate trajectory than what the Fed was projecting in June. However, the futures reflect some chance that the Fed will have to reverse course and lower rates after the initial increase. That risk is not included in the Fed’s projections. Still, financial markets seem to carry some doubt about the Fed’s willingness to begin raising rates.
Looking ahead, the financial markets are expected to remain sensitive to economic reports, especially those concerning the job market and inflation. On July 31, the Bureau of Labor Statistics will release the Employment Cost Index for 2Q15. The first quarter figure suggested that labor compensation might be picking up, reflecting budding inflation pressures and reduced labor market slack. The 2Q15 figure should suggest otherwise.
Federal Reserve Chair Janet Yellen will give her semiannual monetary policy testimony to Congress this week. In the past, this has been an important event for the financial markets. However, Fed communication is a lot more open these days. For example, we have the forecasts of senior Fed officials and the minutes of the June policy meeting in hand. However, there is still scope for financial market participants to learn a bit more.
Over the last several months, Fed officials have made it clear that monetary policy decisions will depend critically on job market conditions and the inflation outlook. Job growth has remained strong. The unemployment rate has continued to decline and is now near levels that were once considered to be consistent with “full employment.” However, that figure presents a false image due to shifts in labor force participation. Some of that is demographics, the aging of the population. The Kansas City Fed’s Labor Market Conditions Index indicates that slack is being taken up, but considerable slack remains.
There are many measures of “core” inflation. One can exclude food and energy. It’s not that these don’t matter. Rather, monthly changes in food and energy are often volatile and we are interested in the underlying trend. Trimmed measures exclude the highest and lowest price changes. The Atlanta Fed’s sticky price index looks at prices of goods and services that change only gradually. Of these measures, the one the Fed focuses on (the PCE Price Index ex-f&e) is trending at the lowest level (that doesn’t mean that the Fed is wrong).
More importantly, the Fed isn’t worried about past inflation; the focus is on future inflation. The drop in energy prices and the strong dollar have put downward pressure on inflation over the last year, but as they stabilize, their impact on inflation will fade. In domestic production, there are no signs of the type of bottleneck pressures that would push prices higher. The labor market is the widest channel for inflation pressure. There are some signs that wage growth has picked up, but the pace has remained relatively lackluster. Average hourly earnings were reported to be flat in June, up just 2.0% from year ago.
Still, the Fed has to base policy on where the economy is expected to be many months down the road. Simply eyeballing the LMCI graph, it looks as if the labor market is on track to achieve some sense of normality in late 2016. The Fed is not going to wait until we get there to begin policy normalization. The best analogy is that while there is no pressing need for the Fed to hit the brakes, it does need to begin taking the foot off the accelerator in the not too distant future.
Yellen ended her July 10 speech on the economy by bringing up the issue of productivity growth, the most important factor in the long-term economic outlook. However, it’s unclear why output per worker has slowed in recent years. A long-lasting low trend in productivity would have important implications for the standard of living, but also for wage growth (slower), interest rates (lower), and the federal budget deficit (wider).
The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.
All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.