Fed officials have signaled that monetary policy decisions will be data-dependent. Hence, financial market participants will closely examine upcoming economic reports. Data are expected to remain consistent with an improving economy and an initial increase in short-term interest rates by the end of the year.
Job growth has been strong over the last several months. While average monthly gains have slowed in the first half of this year, the pace has remained strong. There’s some statistical uncertainty in the monthly payroll figures (which are reported accurate to ±105,000), but the three-month average helps smooth out the noise. Prior to seasonal adjustment, we normally see sharp gains in payrolls in the spring, and the 2015 figures have been consistent with the usual pattern. However, it’s worth noting that the unadjusted payroll figures are trending three million higher than a year ago.
The unemployment rate ticked up in May, but that is likely to have been noise (the rate is reported accurate to ±0.2%). Since peaking in 2009, the unemployment rate has declined. However, the downtrend overstated the improvement in labor market conditions (as many people exited the labor force). More recently, the employment/population ratio has been trending gradually higher, with gains more pronounced in the key age cohort (those aged 25-54). The pace of job growth and the rise in the employment/population ratio suggest that growth is currently beyond a long-term sustainable rate, as firms will eventually run out of people to hire, but we are still a long way from hitting such constraints.
Average hourly earnings picked up in May, but not by much. Such gains are often revised away in the next month’s report. Investors are likely to pay close attention to the June data, but the May pickup appears to be very tentative. Moreover, wage inflation is still far from what is considered normal (Fed Chair Yellen suggested that a good pace would be 3.5% or more).
Real wages are up considerably from a year ago. However, the boost from lower gasoline prices will fade over time. Real wages have trended roughly flat since January. Motor vehicle sales rose sharply in May. However, part of that gain reflected a bounce-back from a soft April. Moreover, the early Memorial Day holiday led to two weekends of heavy sales promotions. June vehicles sales (to be reported on Wednesday) should show moderation. However, even with a pullback in unit auto sales in June, inflation-adjusted consumer spending (70% of GDP) would still be on track for about a 3.0% annual rate in 2Q15.
Financial market participants typically react to the latest monthly figure, ignoring the fact that there is often a lot of noise in the economic numbers. It’s the underlying trends that are important. While we may see some mix in this week’s data, the June figures on consumer confidence, ISM manufacturing, vehicle sales, and employment should remain consistent with an improving economy, more or less in line with Fed expectations.
There was nothing unexpected in the Fed’s monetary policy statement or in the revised economic projections of senior officials. Chair Yellen covered no new ground in her press conference. However, many investors appear to be unsure of the monetary policy outlook and the implications for the financial markets. So, to clear things up...
The Fed’s decision to begin raising short-term interest rates and the pace of tightening beyond that first move will be data-dependent. The focus is on the job market and the inflation outlook. Job market conditions have improved significantly. Monthly growth in nonfarm payrolls has slowed somewhat (a 210,000 average over the last three months, vs. 280,000 in the second half of last year), but is still well above the pace consistent with trend labor force growth. Over the long term, this pace of job growth is unsustainable (as we’d eventually run out of people), but it is clearly welcome over the intermediate period, as excess slack generated from the recession is taken up.
The Fed expects the unemployment rate to edge lower and then stabilize at around 5% over the next two years. Implicit in this forecast is an expectation of a long-awaited rebound in labor force participation. To gauge the amount of slack in the job market, the Fed will continue to examine a wide range of labor market indicators, including participation rates, part-timers wanting full-time employment, quit rates, and wages.
The Fed sees the recent modest trend in inflation as reflecting the transitory impact of low energy prices and a strong dollar. According to Yellen, “inflation is likely to run at a low level for a substantial period of time.” However, oil prices and the dollar have stabilized in the last few months. As transitory impacts fade, inflation should move up. Continued economic growth should eventually put some upward pressure on inflation. Year-over-year growth in wages has ticked higher recently, but as Yellen noted, these signs are “tentative” and “not yet definitive.”
As expected, the dots in the dot plot generally moved lower (relative to the mid-March projections). All but two of the 17 senior Fed officials expect an initial rate hike this year. The difference in the dots largely reflects the difference in economic expectations among the various Fed officials. Some are more optimistic than others. However, there is a lot of uncertainty around each dot and the policy views of each Fed official will evolve according to the incoming economic data.
In her press conference, Yellen emphasized that, for the financial markets, the timing of the initial Fed hike should be less important than the pace of tightening beyond that first move. That trajectory is expected to be very gradual, but it could move higher, if economic growth is stronger and inflation moves higher than expected, or lower and less steep, if conditions were to prove weaker. The Fed will not commit to a mechanical rule on the pace of tightening. However, Fed projections are consistent with about 25 basis points per quarter.
Policywise, not much is expected out of this week’s meeting of the Federal Open Market Committee. The FOMC is unlikely to provide a clear signal on the precise timing of the initial increase in short-term interest rates. However, there should be plenty of information in the Fed’s revised economic projections and in Fed Chair Janet Yellen’s press conference.
The split between the Fed’s hawks and doves is widely overstated. Monetary policy decisions are generally arrived at through a broad consensus. Contrary to a recent op-ed in The Wall Street Journal, monetary policy is determined by the FOMC, not the Board of Governors. Recall that the FOMC sets the target range for the federal funds rate (the overnight lending rate). The Fed’s Board of Governors sets the primary credit rate (the “discount rate,” the rate the Fed charges banks for short-term borrowing) following a request by one or more district banks for a change (which may or may not be approved). The FOMC is made up of the five (normally seven) Fed governors, the president of the New York Fed, and four of the 11 other district banks (who rotate on and off each year). All 17 senior Fed officials participate at FOMC meetings, but only FOMC members get to vote on monetary policy. Still, the FOMC tends to be dominated by the board of governors and the governors tend to be dominated by the views of the Fed chair.
In their public speeches, senior Fed officials have clearly laid out the conditions that would lead to an initial rate hike, but also have listed a few caveats:
1) Officials want to see further improvement in the job market and they should expect that improvement to continue (however, judging how much slack remains and how rapidly that slack is being taken up are open questions, subject to different opinions);
2) Officials need to be “reasonably confident” that inflation will move back toward the 2% goal (the FOMC can hike well before reaching that goal, but the Fed’s track record on forecasting inflation hasn’t been good);
3) The timing of the first rate hike is much less important than the pace of tightening after the initial move (and that pace is expected to be very gradual);
4) Fed officials are aware of possible liquidity issues in the bond market, which could lead to excessive volatility in response to the Fed’s initial move (further reinforcing expectations that the Fed will move slowly);
5) Fed officials are aware of possible adverse reactions in emerging economies (as we saw in 2013’s taper tantrum – the FOMC will do what it has to do, but it also has to take into account the possible feedback from more unsettled reactions abroad).
The Labor Market Conditions Index, a composite of 24 indicators, suggests that slack is being taken up at a relatively rapid pace, but we still have a while to go before constraints hit. The May CPI report (due Thursday) is expected to show consumer price inflation at close to 0% over the last 12 months. Core inflation has remained low. Pipeline pressures are virtually nonexistent. The labor market is the widest channel for inflation pressure. Wage growth appears to have picked up, but not a lot and these figures are tentative. Moreover, Fed officials should be willing to tolerate a moderate pickup in wage growth.
In March, Fed officials lowered their GDP growth projections. Forecasts of the appropriate year-end level of the federal funds rate edged lower. The less aggressive Fed policy outlook contributed to a reversal in the dollar.
Janet Yellen has cautioned against reading too much into minor movements in the dots. Indeed, there is a huge amount of uncertainty in each individual dot (that is, forecast). Market estimates of the path of short-term interest rates, such as seen in the federal funds futures, are more gradual than the most dovish Fed official. Why is that? The Fed’s forecasts reflect the most likely path seen by each Fed official. The market’s forecast is a risk-adjusted expectation. The Fed’s April survey of primary dealers showed that many expected that the Fed might be forced to return to the 0% lower bound after the initial hike.
FOMC members will likely want to see further evidence of a rebound in growth and then, beyond that, further evidence that growth will remain strong. This would put September as the most likely starting point (provided the data are in line with expectations), but the precise timing will depend on the data. The more important issue is the pace of tightening after the first move. In her speech of May 22, Fed Chair Yellen said that she expects that “it will be several years before the federal funds rate would be back to its normal, longer-run level.”
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