Waiting For Something Different

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The April employment report lent further support to the Fed’s gradual approach to rate policy. There is little reason to doubt that central bankers will hike rates at their June meeting while indicating more will be coming in the second half of the year. The report deepened the mystery of low wage growth, putting the Fed in the familiar place of again being overly pessimistic with regards to the unemployment forecast. Meanwhile, central bankers continue to signal they will allow inflation to overshoot their target.

Nonfarm payrolls grew a below-consensus forecast 164k in April while the previous two months were revised up by 30k. The twelve-month pace is holding just below 200k and solid growth in temporary help numbers suggest these numbers are sustainable going forward.

The pace of job growth finally caught up to the unemployment rate. After months at 4.1 percent, the unemployment rate dropped to 3.9 percent, a level last seen in December 2000. The Fed was not expecting to see 3.9 percent until the end of this year; with the overall economy looking sufficiently strong to sustain this pace of job growth, they will almost certainly edged down their unemployment rate forecasts at the next FOMC meeting.

Even though unemployment pierced the 4 percent mark, wage growth continues to disappoint. The monthly gain annualize was just 1.8 percent, while the change from a year ago was 2.6 percent. With inflation rising back to the Fed’s 2 percent target, these numbers suggest real wage growth is decelerating. This strikes me as unsustainable in the face of already low and still falling unemployment rates. Consequently, I anticipate wage growth will tick up higher in the months ahead.

Still, just enough wage growth to match the combination of inflation and productivity growth, let’s say a combined 3 percent, doesn’t suggest the economy is overheating. By extension, the economy thus has not yet pushed past full employment. The Fed’s estimate of a 4.5 percent natural rate of unemployment thus still seems too high and likely to fall in line with downward revisions to the unemployment rate forecast next month. Alternatively, they can hold the longer run natural rate estimate steady with the explanation that it is temporarily depressed. Or they can hold the natural rate estimate steady and raise interest rate projections accordingly.

My current thinking is that they will not look to raise rate projections again just yet. They need to see stronger wage growth to confirm the economy is operating above full employment and to see such overheating reflected in higher inflation. And not just a few basis points of higher inflation, but something significantly more. Via Bloomberg, Atlanta Federal Reserve President Raphael Bostic told reporters:

“We’re fluctuating around the 2 percent target. I am comfortable with that. To the extent we have seen some upward pressure, we don’t have the ability to stop trends on a dime. Some overshoot is fine.’’

This will be the dominant thinking among central bankers for the time being. I think they will be comfortable allowing their near-term inflation forecasts drift higher if need be – up to as high as 2.5 percent even – if those forecasts revert back to target over the medium run under current rate projections. This gives also will give them quite a bit of leeway to accept lower unemployment. Given the flat Phillips curve, even very low unemployment doesn’t generate inflation worth getting upset about.

Bottom Line: Assuming the current path of activity continues and that the Phillip’s curve remains flat and doesn’t have a “hockey stick” moment, I expect the Fed to remain on kind of autopilot. They will tolerate modest overshooting of inflation and instead focus on their forecasts. Those forecasts suggest that the path of expected tightening will suffice to return inflation to target over the medium term. They need to see genuine threats to that forecast before deviating to a new policy path. They will likely raise rates once a quarter until the yield curve flattens out. At that point, policy becomes more complicated – especially if the lagged impact of monetary policy has yet to show up in slower economic activity.

Fed Holds Rates Steady

With incoming data largely supporting the Fed’s economic outlook, central bankers did as expected and left policy rates unchanged. There is little reason to expect the Fed to alter course from the predicted three or four rate hikes this year (barring any slowdown in the data or increase in risks to the outlook, four should be the baseline). The most important news from the FOMC statement was the hint that the Fed would not overreact with substantial policy changes in response to inflation readings modestly above 2 percent. As usual, watch the employment report for signal that the economy will overshoot full employment, but also note that the Fed already expected overshooting.

The Fed concluded their two-day meeting with a statement that was largely unchanged with the exception of updates in response to incoming data. Most notable was the addition of “symmetric” in this line:

Inflation on a 12-month basis is expected to run near the Committee’s symmetric 2 percent objective over the medium term.

Inflation is now very near the Fed’s target and it is reasonable to expect some overshooting of that target. Central bankers are reminding market participants that the inflation target is symmetric such that they will tolerate reasonable short-run deviations from target in the near term. In other words, don’t freak out if inflation exceeds 2 percent as that alone will not drive the Fed to change policy. The Fed is likely to stick to the present policy path unless inflation rises above 2.5 percent and looks like to stay high without a more aggressive policy stance.

The next major release is Friday’s employment report for April. Expect payroll growth to bounce back from a weak March reading; my forecast of a 207k gain is fairly close to the Wall Street consensus of a 190k gain. Job growth running at roughly 200k per month should eventually put downward pressure on unemployment. Or at least this is what the Fed expects as they foresee unemployment falling to a low of 3.6 percent by the end of next year.

That said, unemployment has remained stuck at 4.1 percent for months. This is good news as the labor market keeps kicking out supply to meet demand. The Fed fears this good news will eventually come to an end as the demographics factors eventually catch up to the cyclical forces pulling people into the labor market. Note that this is already build into the Fed forecast, so if it happens soon it should not dramatically alter the path of policy.

Likewise, tepid wage growth belies claims that the economy has surpassed full employment. If wage growth remains low, the Fed will likely continue their downward revisions of their estimates of the natural rate of unemployment. Faster wage growth would reinforce their current views, but again this is already build into the forecast.

Bottom Line: The Fed’s forecast already calls for faster inflation and some overshooting of the full employment objective. This is why central bankers anticipate that interest rates will need to rise above longer-term levels; returning the economy to a sustainably longer run equilibrium requires such tighter monetary conditions in their models. What gets us to a faster pace of rate hikes? Clear evidence that the economy has surpassed full employment in the form of sharply higher wage growth plus either much quicker than expected unemployment declines or evidence that inflation will be sustainably above 2.5 percent. Of course, also watch for the possibility that the Fed foregoes a fourth rate hike this year if the economic activity unexpectedly wanes.

Set To Stay On Current Path

The Federal Open Market Committee begins their two-day meeting this morning, an effort that will almost certainly culminate with steady rates and fairly limited alterations to the accompanying FOMC statement. The underlying message is “steady as she goes.” We have yet to see data break meaningfully to either side of the Fed’s forecast such to expect a change in the pace of rate hikes. With the economic data continuing to support the broad contours of the Federal Reserve’s forecast, we should expect the Fed to remain on track to hike policy rates by 25bp each quarter for the remainder of this year.

Continued here as a newsletter…

Last week the Bureau of Economic Analysis reported that economic growth edged down to 2.3 percent in the first quarter, compared to 2.9 percent in the final quarter of last year. This slowdown, however, is likely less than meets the eye. It has been long suspected that residual seasonality weighs down the first quarter data. Consequently, the year-over-year trend – which continues to rise, supported by solid investment numbers – is arguably a better measure of activity. Moreover, while consumption growth slowed compared to the previous quarter, the underlying pace of 2.5 percent growth has been remarkably steady for more than two years.

Hence, I don’t see much value in agonizing over the quarterly movements in GDP at the moment as the underlying story has yet to change: The economy is operating at a pace that exceeds the Fed’s estimate of longer run growth. Over time, this pace of activity will reduce remaining labor market slack until employment exceeds full employment. In this light, some of the important issues are:

  1. When is the economy at or beyond full employment? The unemployment rate of 4.1 percent is already below the Fed’s 4.5 percent estimate of the natural rate of unemployment. But is the Fed overly pessimistic on this point? So far, tepid wage growth suggests there remains room for further downward revisions to the Fed’s natural rate estimate. But the latest improvement in the employment cost index opens the door to the possibility that wage growth may finally be set to expand. If wage growth accelerates this year, the Fed will become increasingly certain that they have a fairly good estimate of full employment.
  2. But will inflation accelerate? An acceleration of wage growth does not automatically translate into a faster pace of inflation. Productivity might rise in response to higher wages, or profit margins might be squeezed. Faster wage growth thus by itself only gives policy makers confidence in their estimates of full employment and, by extension, provides the justification for further rates hikes to limit the extend the economy overshoots full employment.
  3. How much inflation overshooting will the Fed tolerate? Core inflation has rebounded to 1.9 percent year-over-year, pretty much in line with the Fed’s 2 percent target. The Fed’s hence accurately predicted that last year’s inflation shortfall would prove transitory. The inflation rebound again justifies the Fed’s outlook but does not by itself argue for a faster pace of rate hikes. Nor would modest overshooting of the target increase the pace of rate hikes. The Fed would likely tolerate inflation as high as 2.5 percent as long as they could reasonable forecast a return to target over the medium term given the expected current path of policy rates. Note too that any expectation of inflation overshooting remains premature. Monthly inflation decelerated below 2 percent in March; there may be some new seasonal effects in the data as firms increasingly concentrate price changes near the start of the year. Moreover, there remains downward pressures on shelter costs which will weigh on overall inflation.
  4. Growing downside risks? Although activity remains consistent with the Fed’s forecast, there is always a risk that the current tailwinds revert again to headwinds. Supply chain disruptions stemming from international trade disputes, for example. More concretely, there is growing evidence of decelerating global activity. In short, it is worth remembering that many things fell into place for the US economy after the 2015-16 soft patch. Streaks of good luck eventually come to an end.

Bottom Line: I anticipate the Fed will continue to hike interest rates; best bet is that policy rates edge up 25bp a quarter for the rest of the year and into next. I am watching for risks to both sides of this forecast, but at this point those risks have yet to materialize into reality. Considering the resilience of very long rates to policy tightening, I anticipate that further upward pressure on rates remains concentrated on the short-end of the yield curve. I suspect the Fed continues to hike rates until they flatten out the yield curve – at that point policy makers will face some more significant challenges.

Note: Sorry for the brief hiatus from Fed watching. Other job/family duties needed my attention for a bit.

Employment Report And Catching Up

I am still catching up from Spring Break. First, from my Bloomberg piece this week:

The turmoil in equities continued this week with the S&P 500 Index down about 10 percent from its record high in January. Although the sell-off implies tighter financial conditions, don’t expect the Federal Reserve to change course yet.

Central bankers will need more evidence that Wall Street’s problems threaten to spill over onto Main Street before they abandon plans for further interest-rate increases. Friday’s employment report is more important for the path of rates than recent financial market action.

Continued here on Bloomberg…

With this in mind, the consensus for this employment report is a nonfarm payroll gain of 175k (compared to 313k in February), a slight decline in the unemployment rate to 4.0 percent, and a 2.7 percent y-o-y rise in wages compared to last year. Numbers along these lines would be generally consistent with the Federal Reserve’s forecast, which anticipates that continuing solid job growth will push the unemployment rate down to 3.9 percent this year and 3.6 percent next year. Hence, an employment report meeting the market expectation implies the Fed will remain on course to hike rates three or four times this year (recall that the median rate forecast for 2018 is for three hikes, but the bulk of FOMC participants are split between three and four hikes; four should be our baseline at this point).

Interestingly, strong ISM employment components and ADP’s estimate of private payrolls, combined with low unemployment claims, leads my model to an above consensus forecast of a 243k gain:

This seems high to me given that the February number experienced a death-related boost; recall also significant March reversals in 2017 and 2015. We should be prepared for the possibility of a sharp downward miss on payrolls. Still, given concerns about headwinds changing to tailwinds when the economy sits near full employment, the Fed will be more sensitive to a stronger than anticipated report than the alternative. A weak number on payrolls would be written off as payback from February.

Importantly, look for signs that the economy has pushed beyond full employment; a stronger than expected wage number would suggest the Fed’s estimate of longer-run unemployment is close to accurate. It wouldn’t necessarily push the Fed to accelerate the pace of rate hikes – the link between wages and inflation is not so straightforward – but would suggest the risk to the forecast is tilted toward more (or sooner) hikes than anticipated.

Finally, the path of monetary may clear further after Federal Reserve Chairman Jerome Powell’s speech Friday. I am hoping for more frequent discussions on the economy from Governors in general and the Chairman in particular than we have had in recent years.

And while we wait, here is a picture of Zion National Park I took while on Spring Break:

 And here is Death Valley:

The Fed Bets on Overshooting Its Inflation Target

The Federal Reserve concluded its March meeting on Wednesday with a widely expected 25 basis-point rate hike and a promise of more to come. The accompanying Summary of Economic Projections also signaled that the Fed expects to overshoot its inflation target. Within the context of the central bank’s framework, policy makers have little choice but to accept some overshooting of inflation. The alternative is a much costlier recession.

Continued at Bloomberg Prophets…

Questions for Powell

Market participants widely expect the Federal Reserve to raise interest rates at the conclusion today’s FOMC meeting. The only real debate surrounding this meeting regards the Fed’s messaging. Central bankers pivoted to a more hawkish stance in recent weeks, and this shift will be reflected in the statement and accompanying Summary of Economic Projections. But will it be modestly or very hawkish, or somewhere in-between?

Federal Reserve Chairman Jerome Powell’s debut post-FOMC press conference should provide guidance on this issue.With that in mind, these are the questions I am hoping he will answer the following questions either directly or indirectly:

  1. How does “avoiding overheating” compare to “sustaining full employment”? In his most recent Congressional testimony, Powell shifted the language regarding the Fed’s policy objective to “avoiding overheating.” Does this mean the Fed’s focus is now on restricting the pace of growth more forcefully?
  2. What is the Fed’s level of confidence in the estimates of the longer-run level of unemployment? The unemployment rate is projected to sit well below the longer-run non-inflationary rate for a protracted period of time. Their willingness to tolerate this situation suggests they are not very confident in this estimate and are willing to allow the unemployment rate to fall even further than the currently forecasted low of 3.9 percent.
  3. Even if they are not very confident of the exact level of longer-run unemployment, is there a red line they fear to cross? In his Congressional appearance, Powell said the natural rate of unemployment may be as low as 3.5 percent. That is a level not seen for five decades and then seemed to trigger high inflation. Would they be willing to flirt with that level again? Or an even lower number?
  4. Is the Fed willing to invert the yield curve? The yield curve resumed flattening in recent weeks, taking the spread between 10 and 2 year securities to 55 basis points. The Fed’s forecasts indicate the Fed intends to raise rates beyond the longer-run neutral policy rates, suggesting they intend to flatten the curve further. Would central bankers deliberately invert the yield curve – or continuing hiking after an inversion – given that in the past such behavior has preceded recessions?
  5. How much of any increase in the rate hike projections is directly attributable to fiscal stimulus? Fiscal stimulus is one of the tailwinds supporting US growth this year and next. Given the economy was already projected to operate beyond the Fed’s estimates of full employment, the fiscal stimulus will only exacerbate the risk of overheating. How much is the Fed leaning against fiscal stimulus?
  6. What is the definition of “gradual” rate hikes? Suppose the Fed raises the rate projections to a full four hikes this year and three next. Is that still gradual? What if central bankers revise up rate projections again in June?
  7. Is the Fed looking to replace inflation worries with financial instability concerns? Federal Reserve Governor Lael Brainard recently said that in the last two cycles, overheating became evident not as price inflation but instead as financial instability. Does this mean that Fed intends to pivot to financial stability concerns to justify rate hikes if inflation continues to remain low? What financial stability objective is the analogue of the inflation target?
  8. How lopsided are the balance of risks to the outlook? Brainard described the current economic situation as the mirror image of 2015-16. The Fed sharply decelerated the actual pace of increases then relative to expectations. Should we be prepared for the opposite, a sharp acceleration?

Bottom Line:  Why do the answers to these question matter? Right now, the economy is in a “sweet spot” with enough upward pressure to support ongoing improvement in labor markets yet not so much that inflation is a concern. Sustained activity in this territory will deepen and broaden the benefits of this expansion to a greater share of the population. Moreover, by moving gradually the Fed has been able to extend the life of this expansion. Indeed, the odds favor that this expansion will be record breaking in length. When the Fed turns hawkish and steps up the pace of rate increases, however, is when we need to be increasingly concerned that, like all good things, this expansion will come to an end.

Rate Hike On The Way

Market participants correctly anticipate that the Federal Reserve will hike interest rates at the conclusion of this week’s FOMC meeting. The accompanying statement and economic projections will compare hawkishly to previous iterations from past January and December, respectively. But how hawkishly? While the “dots” representing individual interest rate forecasts will rise, they may not yet rise enough to signal a fourth rate hike this year.

We are covering some well-worn ground at this point. Central bankers began sounding a more hawkish note with Federal Reserve Chairman Jerome Powell’s testimony before Congress. Powell’s “headwinds to tailwinds” story was fleshed out further in a speech by Federal Reserve Governor Lael Brainard. A particularly salient point of that speech was Brainard’s analogy of the current situation as the “mirror image” of the situation facing the Fed in 2015-16. During that period, the Fed sharply scaled back the expected pace of rate increases. The implication then is that the Fed may sharply raise the pace of rate hikes this year.

Still, it is not evident that they in fact need to accelerate the pace of rate hikes beyond the expected three. In general, incoming data on growth, unemployment, and inflation appears broadly consistent with the Fed’s expectations for this year. Sufficiently consistent that, considering the economic tailwinds from global growth, fiscal stimulus, and easy financial conditions, those FOMC participants who viewed two rate hikes as likely will up their forecasts to three.

The doves snugging up their policy forecasts will raise the average rate hike expectation, but this by itself would be unlikely to lift the median forecast. To lift the median, central bankers already confident with the inflation forecast will need to respond to freshly announced fiscal stimulus by raising their projections as well. It is not clear to me that enough of the current three dotters raise their forecasts to bump up the median to a full four hikes this year.

I am more confident that the median rate hike expectation for 2019 will rise to a full three hikes, and that we will see the 2020 rate projections rise as well. The additional fiscal stimulus announced since the last FOMC meeting suggest above-trend growth will persist longer than anticipated. The Fed will tend to believe policy needs to be somewhat tighter to compensate.

Other things to look for:

  • The longer-run policy rate. My expectation is that increases in the near- and medium-term rate projections will exceed any increase in the longer-run, or neutral, policy rate. That would suggest that central bankers anticipate that they are not chasing the long-end of the yield curve to hold policy neutral. Instead, they anticipate that they are reducing accommodation in an effort to slow the pace of activity. That would imply a flatter yield curve in our future.
  • The longer-run unemployment rate. The ongoing persistence of tepid wage growth opens up the possibility the Fed might lower its estimate of the longer-run unemployment rate. That might weigh against any declines in the unemployment forecasts for this year and next that may occur if fiscal stimulus raises the growth forecasts.
  • Commentary on the balance of risks. In his testimony, Powell said that the goal of policy was now to avoid overheating. That implies that the balance of risks are weighted toward inflation. Similar holds for Brainard’s comments about tailwinds to activity. Consequently, I think we should be looking for a signal in the statement communicating that the path of policy is more likely to be tighter than anticipated than looser.
  • Press conferences at every meeting? There is a possibility that Powell opts for a press conference at each meeting. This would make every meeting truly “live,” compared to now when meetings without press conference are only sort of “live.” It would also open up more of a possibility that the Fed could front load some of this year’s expected hikes.
  • Possible extra hawkish surprise in the dots? The Fed tends to be slow moving outside of a crisis. That one reason why we might not see enough dots move up to push the median forecast to four hikes for this year. But we could have a hawkish surprise if some participants up their forecast by 50bp instead of 25bp. That seems unlikely, but not impossible if, for example, increase confidence in the outlook was with 25bp and fiscal stimulus worth another 25bp.

Powell will of course use the press conference to emphasize (or not) any feature of the statement or projections as he deems necessary. Overall, I think he will want to continue to thread the needle between signaling the possibility of an even faster pace of rate hikes while maintaining the language of gradualism.

On another note, we should keep an eye on the recent LIBOR-OIS spread widening. It seems reasonable that no single reason accounts for the widening, but rather a combination of Fed rate hikes, the threat of more rate hikes, balance sheet reduction, dollar repatriation, and fiscal policy. As these issues become more fully priced into markets, we may see the spread narrow. Something to watch for: Perhaps one can argue that we are seeing the impact of tighter monetary policy? It would be interesting if the Fed sees it the same way.

Bottom Line: Increased confidence in the outlook and more fiscal stimulus when the economy may already be at full employment sets the stage for the Fed to boost rates and rate forecasts. But they will be wary of spooking the markets with too much hawkishness. Look for the Fed instead to describe the more hawkish policy stance as still gradual, but with the possibility that something less gradual may be near.

Inflation Still Soft

Consumer price inflation eased back from the January spike, silencing concerns that inflation would soon make a comeback. This will help keep the Fed focused on its gradual tightening path. If they want to shift gears, they will have to look elsewhere.

Core CPI decelerated in February to 0.2 percent month-over-month, compared to a 0.3 percent gain the previous month. The annualize monthly gain was 2.2 percent. Be wary of reading too much into the three-month gain of 3.1 percent as that will quickly come down if the monthly readings stay low.

It is worth considering that the stronger December and January numbers reflected some unaccounted for seasonal factors. Given the low inflation environment, the numbers of times firms change prices during the year decreases, and the timing of those changes are concentrated around the beginning of the year (a natural time to change prices). If so, then the December and January numbers were largely transitory.

Two additional points in this quick post. First, with multifamily housing starts holding strong, gradually declining shelter inflation will likely continue to weigh on overall inflation. Second, PCE inflation, the Fed’s actual inflation target, traditionally runs roughly 50bp below core. So a 2.2 percent core CPI inflation implies something like 1.8 percent core PCE inflation. That is still weak relative to the Fed’s two percent inflation target.

Bottom Line: Inflation numbers help confirm the Fed’s current forecast, but don’t signal any overshooting of their target yet. The Fed hence can’t yet place an accelerated pace of rate hikes on the back of actual inflation. Changes in the rate forecast instead remain attributable to risk management considerations as tailwinds threatens to push the economy into overheating that would reveal itself in either excessive inflation or financial instability.

Jobs Report Gives Fed Cover To Retain Gradual Rate Path

The jobs report gives the Fed cover to retain a gradual rate path. To be sure, the rapid pace of job growth will leave them nervous about an unsustainable pace of growth. But the flat unemployment rate remains consistent with their forecasts. In addition, low wage growth indicates the economy has not pushed past full employment. If inflation remains constrained, the Fed would be pretty much on target for this year. That suggests the three-hike scenario should remain in play. But increased confidence in the outlook and risk management concerns will push up enough “dots” in the next Summary of Economic projections toward four hikes for this year.

Continued here as a newsletter…

Nonfarm payrolls grew by in February while previous months were revised upwardly. The three-month moving average is 242k while the twelve-month average is 190k. These are solid numbers for an economy this deep into an economic expansion, the result of the acceleration of activity over the past year.Job gains continue to exceed the rate at which central bankers believe will eventually be the rate of labor force growth when secular factors dominate cyclical behavior. That time, however, continues to be postponed. The unemployment rate held steady again at 4.1 percent; my concerns that unemployment would soon shift downward continue to be just concerns and not reality. Instead, growth in prime-age labor force participation continues to support overall labor force participation. If this trend continues, then we would expect that the unemployment rate will generally track in line with the Fed’s forecast despite growth well in excess of long-run potential growth.More generally, the recovery of prime-age participation (alone with still relatively high levels of other underemployment indicators) suggests that the economy can sustain further cyclical gains without overheating. In other words, the economy might be quite a bit farther from full-employment than indicated by Federal Reserve estimates of the longer-run unemployment rate. Weak wage growth also argues against the full-employment hypothesis. Wage growth decelerated in February, quelling hopes for a more sustained acceleration.Although wage growth decelerated, hours worked jumped, which will help support overall compensation and provide a base for continued consumer spending. In addition, a jump in temporary help payrolls indicates this labor market isn’t about to hit a wall anytime soon.

The Federal Reserve should be comforted by this report as it argues in favor of the gradual rate hike approach. If labor supply is responding positively to a higher pace of economic activity, the Fed should worry less about overheating despite the solid pace of wage growth. Moreover, continued tepid wage growth should weigh down on their estimates of full-employment. This report simply doesn’t indicate that the natural rate of unemployment is as high as the Fed believes.

This report should, like recent inflation numbers, reassure the Fed of its 2018 forecasts. That will induce those policymakers most skeptical of the inflation outlook to revise their below-consensus rate estimates higher, bumping up the lower dots. In addition, with their forecasts looking likely to hold, those at or above consensus would be expected to hold their estimates steady. There will, however, be upward pressure to rate even those dots.

Risk management concerns will drive the upward pressure on rate projections. The Fed tends to believe the economy has more likely than not achieved or surpassed full employment (regardless of that pesky wage, inflation, and labor force participation data). They also see headwinds changing to tailwinds that threaten to sustain stronger growth for longer than expected that pushes the economy deeper into a danger zone in 2019 and 2020. Finally, the last two cycles left central bankers wary that a hot-economy will reveal itself in financial instability rather than inflation. All together that suggests they will want to project a slightly tighter policy and be prepared to move more aggressively if needed. This will reveal itself in the next Summary of Economic Projections.

Bottom Line: Recent employment reports combine to tell a story of an economy that can sustain a faster pace of growth without pushing past capacity boundaries. That argues for leaving the Fed’s expected policy rate path intact. But Federal Reserve Chairman Jerome Powell’s testimony pointed to “avoiding overheating” as a policy objective while Federal Reserve Govenror Lael Brainard discussed at length the shift of economic forces from headwinds to tailwinds. She drew a comparison to 2015-16, when the Fed sharply reduced the pace of hikes relative to the projected rate path. Together, these discussions suggest the Fed sees a shifting balance of risks to the outlook. They will try to manage the risks accordingly, bumping up estimates of future rates while leaving open the option to switch to a more sharply more aggressive path if needed.

Employment Report Coming Up

Some of the fog around monetary policy lifted in recent days. Central bankers, increasingly confident on the inflation outlook, look to be firming up their rate forecasts. In practice, this means that those who were wary that inflation would rebound as expected will likely raise their “dots” up a notch toward the current median expectation of three dots. See, for example, Atlanta Federal President Raphael Bostic. It is not clear yet if those who were already confident of the inflation forecast will raise their policy expectations. Hence, the 2018 dots might climb but the median remains at three rate hikes. In addition, given current momentum in the US economy, fueled by tail winds from just about everyone, there remains room to pull up the 2019 and 2020 dots.

A March bump in rate forecasts, however, overlooks a bigger issue. Uncertainty over the rate forecast is growing – but not symmetrically. The risks are shifting toward a greater pace of rate hikes. The existing forecast already contained plenty of upside risk for rates. But the addition of fiscal stimulus threatens to push the unemployment rate into a region in which the Fed has little experience. The situation, according to Federal Reserve Governor Lael Brainard, is essentially a mirror image of 2015-16. Then, the Fed sharply slowed the pace of rate hikes relative to expectations. The mirror image risk is that central bankers sharply raise the pace.

Nothing of course is written in stone at this point. We don’t yet know when or if the economy would overheat. But the Fed may have to react quickly if it does.

With that in mind, central bankers will carefully scour the employment report for signs of potential overheating. In a broad sense, we would see that in three places – job growth, unemployment rate, and wage growth. The consensus forecast for nonfarm payrolls is for a gain of 205k in a range of 152k-230k. My estimate is 208k, leaving me in line with the consensus.

The Fed estimates job growth of only roughly 100k is necessary to hold the unemployment rate steady. Hence, continued job growth well in excess of that number will be looked upon warily. In the near term, gains in labor force participation may hold the unemployment rate steady. Over the medium term, however, that pace of growth will eventually place downward pressure on unemployment and increase the degree by which the economy overshoots full employment.

Indeed, job growth already exceeds labor force growth, but the unemployment rate has remained steady in recent months. The consensus expectation is for unemployment to dip slightly to 4 percent. I still remained concerned that unemployment will lurch lower in a fairly short amount of time – such a development would clearly rattle the Fed. Mark Zandi of Moody’s Analytics is forecasting a 2.5 percent unemployment rate by next summer under the Fed’s current rate path.

Then there is wage growth, which perked up in December and January. Wall Street expects wages to be up 2.9 percent compared to last year, the same as in January. The acceleration in wage growth in recent months gives fresh supportive evidence to the hypothesis that the economy is near full employment; an acceleration would add to that evidence.

It is important remember that an acceleration in wages does not necessarily imply an acceleration in inflation. Wage growth could be absorbed by profit margins instead. In theory, that means the Fed would not should not respond reflexively to a wage acceleration – they target inflation, not wages. In practice, however, Brainard indicated that in the last two cycles, the imbalance of an overheated economy became reflected in financial instability rather than inflation:

We also seek to sustain full employment, and we will want to be attentive to imbalances that could jeopardize this goal. If the unemployment rate continues to decline on the current trajectory, it could fall to levels that have been rarely seen over the past five decades. Historically, such episodes have tended to see elevated risks of imbalances, whether in the form of high inflation in earlier decades or of financial imbalances in recent decades.

This suggests that the Fed might be incline to tamp down growth even in the absence of inflationary pressures.

I am not sure I am a big fan of Brainard’s interpretation. I would like to better understand the causality. She seems to imply that low unemployment rates caused financial instability. I tend to think of it the other way around – that the financial instability of asset bubbles drove clear surges of investment activity. The subsequent activity drove down unemployment. In this cycle, activity is much more broad-based with no single sector outperforming on the back of an asset bubble. I am not sure they should take the focus off the price mandate for a less defined financial stability mandate.

Bottom Line: With the economy nearing full employment, or having already overshot full employment, the Fed will find it hard to rest easy until job growth eases back to something they believe to be a more sustainable pace. But they are less likely to shift dramatically away from a gradual pace of rate hikes as long as unemployment hovers close to four percent and wage growth doesn’t leap higher. Of course, this would become less relevant if inflation made a stronger appearance. In that case, it would be more evident they pushed past critical boundaries for activity and need to respond more forcefully.