Between now and the middle of December, the Fed is going to try to determine “whether it will be appropriate to raise the target range at its next meeting…” That’s how the FOMC statement put it after the last policy meeting. It describes a course of action; raise rates. It suggests a bias to act –urgency that was missing from the September FOMC statement. Back then, the FOMC only wanted to determine “how long to maintain this target range...” But now, the Fed has a goal – raise the rate – and a timeline – by the next meeting. The question is how they make the determination, whether the data on which they depend must jump further ahead, or simply not fall on its face.
In order to make this determination, the Fed says they will “assess progress—both realized and expected—toward its objectives of maximum employment and two percent inflation.” You know the drill; it’s a dual mandate sort of thing. Specifically, the FOMC statement says “This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings of financial and international developments.” But for those of you keeping score at home, what follows is a bit of a cheat sheet.
Measures of Labor Market Conditions
The cumulative achievements of the headline labor market data have long since risen above and beyond any threshold that requires the funds rate to be at the zero bound. The unemployment rate has fallen from a peak of 10% down to 5.1%, a level that is just a stone’s throw from the Fed’s view of full employment. The nonfarm payrolls have averaged a monthly increase of 210k for the last forty-eight months; the best streak since the turn of the century.
It is true that the pace of job creation has slowed. The six-month average was +280k at the end of 2014, it is down to +199k now and the last two months are the weakest back-to-back results in more than three years. Furthermore, the recent revisions have been to the downside. So I guess it is possible that a couple of bad payroll reports between now and the December FOMC could be enough to make the Fed think twice, but the results have to be stinky, and not just mediocre.
San Francisco Fed boss John Williams is not alone in his calculation that any payroll figure in excess of 100k is enough to keep driving down the jobless rate. So for payrolls to be the reason for the Fed stand pat, especially given the body of work over the last four years, the next two figures might have to bluntly reinforce the recent subpar performance; suggestive that the downtrend in job growth is gaining speed and not merely a speed bump.
While it is true that the cumulative gains in the unemployment rate and the payrolls speak well of these indicators, they do not tell the whole story, says Chair Yellen whenever she is asked. She often explains that the Participation Rate is too low, the number of involuntary part-time workers is too high, and wage growth is subdued, and says, therefore, that cyclical weakness remains in the labor market.
But does knowing about these shortfalls help with gauging the likelihood of a Fed rate hike in December? Because if these three indicators need to be resolved before the Fed makes a move, then I don’t know how that can happen in just six weeks. But the Fed says they want to figure out if “it will be appropriate to raise the target rate at its next meeting…” Those two goals seem to me to be mutually exclusive.
The Participation Rate set a new cycle low in September, at 62.4%; the lowest rate in almost four decades. Blame the baby boomer bulge for some of the decline, but the core of the labor market, 25 to 54 year olds, have a participation rate at its lowest level in three decades. This won’t work itself out before Christmas.
The number of involuntary part-time workers is down from its peak, but still about 40% higher than it was when the rececession began at the end of 2007. While this is a good measure of the vibrancy of the labor market over the long run, the story is not going to go away in a timely manner and because of that its not of much use in handicapping the Fed’s next move.
The annualized growth rate of wages was over 2.5% when the jobless rate hit 10%. Wage growth is now below 2% and the jobless rate is 5.1%. The math is wrong and a recalculation won’t be sussed out in a few weeks time.
Indicators of Inflation Pressures and Inflation Expectations
The PCE inflation measure is at 0.2%; well short of the Fed’s inflation target of 2.0%, a level last hit three and a half year ago.
The PCE Core infaltion rate follows a smoother path than the headline PCE and is considered by the Fed to be a better guide to the future path of inflation than is the headline reading. The Core rate is currently at 1.3%. This measure of inflation has been at or near the Fed target in just five month over the last seven years. It is not now trending up toward the target, it has been going sideways throughout the calendar year and is on pace to be the lowest annualized average in five years.
But don’t worry about slack inflation getting in the Fed’s way. The bar here is set pretty low in the sense that the Fed need only be “reasonably confident that inflation will move back to its 2 percent objective over the medium term.” And reasonable confidence doesn’t’ depend on a tick this way or that, but more on the belief that the inflation dampening effect of low energy prices will prove to be transitory; that’s the Fed’s story and so far they are sticking with it.
But the story is a little different for the inflation expectations component. Inflation expectations are a big deal for central bankers; to a degree that may be underestimated by the market.
In her late September speech called Inflation Dynamics and Monetary Policy Chair Yellen talked extensively about the crucial role inflation expectations plays in determining the longer run inflation trend and thus its importance to central banks:
“A key implication of these two examples,” explained Yellen, “is that the presence of well-anchored infaltion expectations greatly enhances a central bank’s ability to pursue both of its objectives—namely, price stability and full employment. Because temporary shifts in the rate of change of import prices, or other transitory shocks have no permanent influence on expectations, they have only a transitory effect on inflation. As a result, the central bank can ‘look through’ such short-run inflation disturbances in setting monetary policy, allowing it to focus on returning the economy to full employment without placing price stability at risk. Indeed, the Federal Reserve has done just that in setting monetary policy over the past decade or more. Moreover, as I will discuss shortly, there inflation dynamics are a key reason why the FOMC expects inflation to return to 2 percent over the next few years.”
Ergo, if inflation expectations are not stable, but are falling, despite years of Fed accommodation, falling unemployment and rising payrolls, there might be a problem with the future path of inflation.I don’t want to infer that expectations are coming unhinged and deflationary psychology is taking hold. But the Fed favorite survey based inflation expectation measure – the 5/10 Year Inflation Expectation from the University of Michigan survey of consumers – just matched a historic low in October. As seen in the chart below, inflation expectations have fallen from 2.8% in July down to 2.5%, a level that was hit just once before, back in 2002. While this downtick has not set Fed hair afire, another downtick in November might create a nervous tic or two at the central bank.
Market based measures of inflation expectations are also closely monitored by the Fed, though they do seem to harbor some skepticism on these. I am not sure that I would use the term “stable” to describe the five year/five year forward inflation swap rate.
Financial and International Developments
“In terms of thinking about financial developments and our reaction to them, I think a lot of the financial developments were really—so, we don’t want to respond to market turbulence,”said Chair Yellen at the September FOMC press conference.”The Fed should not be responding to the ups and downs of the markets, and it is certainly not our policyh to do so. But when there are significant financial developments, it’s incumbent on us to ask ourselve what is causing them. And, of course, while we can’t know for sure, it seemed to us as though concerns about the global economic outlook were drivers of those financial developments. And so they hasve concerned us in part because they take us to the global outlook and how that will affect us. And, to some extent, look, we have seen a tightening of financial conditions during—as I mentioned, during the intermeeting period. So the stock market adjustment, combined with a somewhat stronger dollar and higher risk spreads, dow represent some tightening of financial conditions.”
That really is not as confusing as it might sound on first read. Basically, what it means is that the Fed won’t raise rates when the stock market does anything like it did in late August.
Simple really...you can score that one from home.