Waiting For Something Different

Click for newsletter version!

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.