Fed: A Gathering Confidence

Published on November 7, 2014

It would not surprise Federal Reserve officials if this morning’s Nonfarm Payroll came in at a healthy level. But whatever the breakdown of the numbers in this particular data point, the trend for a large majority of the Federal Open Market Committee is still pointing towards steadily shrinking slack in the labor market and real growth that still looks to be running at a near 3% pace.

This gathering confidence in the sustainability of the recovery drove the slightly more hawkish tone to the FOMC’s October meeting statement, and it likewise seems likely to shape the basic messaging of Fed speeches over the next few weeks, perhaps including the remarks due by Fed Chair Janet Yellen in Paris later today.

A few quick points to perhaps frame the NFP and other data in the run-up to the FOMC’s mid-December meeting:

*** First, despite concerns the stronger dollar may dampen growth or push US inflation dangerously lower, many Fed officials question how much of a cost there is to the strong currency at all. Whatever impact there may be on exports, for instance, could be more than offset by the net stimulus to global demand from a recovering Europe and Japan, or deficit spending by the oil producing countries. Most of all, lower prices for dollar-denominated oil and other commodities is providing a major boost to US domestic demand. ***

*** Second, the stronger dollar and lower energy costs will also add to the downward pressures on already low US inflation, especially headline inflation. But as long as the economy is growing and inflation expectations remain anchored, inflation is expected to trend “sticky sideways” which, on the margin, increases real wages and, on the policy front, lends the Fed considerable running room on the gradual pace of its coming rate tightening. ***

The Dollar Impact

Fed officials are somewhat reluctant to proclaim their optimism on growth after so many years of overstating growth expectations. But this time, their confidence is rising that the pace of growth does seem to be settling into a modestly higher rate than that of the previous years of a subpar recovery.

When it comes to weighing the impact of the stronger dollar, for instance, the distinction must be drawn in the impact on the tradable versus non-tradable sectors of the US economy in both demand and inflation.

And as we wrote previously (SGH 10/16/14, “Fed: Not as Bad as all That, Probably”), the real surprise in the dollar strength was not in that it was strengthening, but in how long the strong Euro had persisted before weakening against the dollar since summer. Much of the effects of a rise in the dollar has been already penciled into the US growth forecasts for much of this year, and was taken as a natural consequence of the better US growth and higher yields compared to risk free returns in Europe or Japan.

The strength in the currency may in time make US exports more expensive and less competitive and thus lower the contribution to growth from the tradable sector, but it is not clear how long that will last or to what extent US companies have hedged or are able to adjust to their higher price in foreign markets. In time, the real pay-off abroad is the boost to the prospects for recovery in Europe and Japan in their weaker currencies (see SGH 10/31/14, “Japan: QQE, Yen, and the Looming Sales Tax Hike”).

Meanwhile, the stronger currency has little to no impact on the much larger non-tradable sectors of the US economy, where it is even providing large benefits rather than costs, which is helping to boost aggregate demand.

For instance, the stronger dollar is helping to underpin the falling oil prices as well as the prices across the commodities complex. The boost to US consumer spending in the lower gasoline, home heating oil, and other energy costs far outweighs any distributional effects or impact on oil industry investments.

What’s more, the lower oil prices are providing a net boost to at least some degree in global fiscal stimulus, as the oil producing countries are unlikely to cut domestic spending programs and will resort to deficit spending to offset their falling revenue.

The inward capital flows reflected in the stronger dollar is adding still more stimulus to US growth because it helps to push US yields lower, which helps to keep borrowing costs down, especially in mortgage financing.

And while the stronger dollar was essentially already factored into the Fed’s growth forecasts, the persistently low US interest rates was largely unexpected and is providing still another fillip to demand.

Benefits to Low Inflation

Fed officials do remain quite concerned over the central bank’s persistent inability to hit its inflation target for these last few years, and they do watch market pricing of inflation expectations.

Indeed, that inflation has persisted below its 2% medium term inflation target for years was enough of an issue to draw a dissent to the last FOMC statement from Minneapolis Fed President Narayana Kocherlakota. And much has been made in the market as well over the decline in the pricing of inflation expectations in the TIPS spreads and five year/five year forwards.

But on the latter, the Fed acknowledges and is monitoring the market measures but puts more weight on the real economy surveys of inflation expectations that are less volatile than the market measures and they, such as the Michigan surveys of inflation expectations have remained remarkably steady.

For the most part, the Fed still believes it is much more likely that inflation will trend “sticky sideways” as long as the current pace of growth continues and inflation expectations remain firmly anchored.

Their confidence core inflation will remain low rather than fall to European or Japanese levels also gives the FOMC considerable running room in how it approaches its rates policy.

What’s more, low inflation in itself will not preclude a rates lift-off or necessarily delay its start (see SGH 10/3/14, “Fed: A “Patient” Reaction Function”), but a slowly rising inflation does mean the trajectory of the rate tightening to remove monetary accommodation can remain gradual. It is, in fact, a central reason behind the March statement that rates are likely to be below normal for a while.

Bracketing the Rates Lift-off and Reaching Neutral

One way Fed officials are increasingly framing their approach to the coming rate tightening is to bracket the arc of the rate path on each side of when the assumed mandate levels for unemployment and inflation will be reached.

A first rate hike off the zero lower bound would in the current scenario come sometime in 2015, or about a year before unemployment and inflation will reach their target levels, which will be sometime in 2016, and the assumed neutral interest rate would be reached about a year after reaching those targets, or sometime in 2017.

As we have been writing for some time (SGH  9/23/14, “Fed: The Dots and the Trajectory”), we think a majority of the FOMC is penciling in June next year as the most likely fulcrum around which “sooner or later” language rotates — which made its way into the formal October statement. We put fairly low odds on the sooner side of the equation, despite the wholly respectable current pace of growth and decline in the unemployment rate.

But if the NFP comes in even stronger than expected, or average hourly earnings shows an unexpected uptick, maybe those odds will begin to rise, or at minimum, the market short rates pricing will move a bit closer to the “blue dot rate plot” survey of the FOMC’s assumed first rate hike and year end projections for the fed funds range target.

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