Fed: A September Pause

Published on May 22, 2017

With the most recent economic data sending somewhat mixed signals on the outlook, and with impeachment chatter in the rearview mirror as President Trump tours the Mideast, attention is turning to the expectations for the Federal Open Market Committee’s June 13-14 meeting.

*** On rates policy, there are no indications the Federal Open Market Committee is backing off its forecast for above trend growth or its signaled intentions for a relatively quickened pace of rate policy normalization this year. Washington’s political chaos will not be a factor. We still expect a third rate hike in just six months at the June meeting, which would bring the fed funds target range to 1%-1.25%. ***

*** Beyond June, however, the Fed’s optimism on the outlook is likely to be sorely tested. Unless inflation data clearly turns towards confirming rather than just conforming to the forecasts, the bad optics of a renewed softening in inflation, coupled to what we believe will be an even more elevated political turmoil in Washington after the August recess, is likely to tip the balance within the FOMC towards a pass on a September rate hike. ***

Unusual Labor Market Dynamics

The Fed messaging, even among most of the more dovish-leaning FOMC members, has in recent weeks pressed the case that the softness in the first quarter data will prove to be “transitory,” with a clearer sense of the underlying trend of above trend growth, a slowly tightening labor market and an upward trajectory in price pressures, soon to come through in the upcoming data.

The translation in policy terms is to an FOMC that will look through the soft numbers to raise rates at the June meeting in three weeks, for the third time since the December rate hike, the fourth overall since the start of rate policy normalization in December 2015. If for anything else, a June rate hike, even if built around the forecast assumptions, is for an FOMC majority providing policy flexibility in picking its spots for the “one or more” rate hikes anticipated before year-end.

It was, we recall, a similar argument laid out for the March rate increase, a tactical hike to maximize the Fed’s flexibility for timing its pace of rate hikes through the year. And, as we wrote previously (see SGH 2/22/17, “Fed: Hello March”), the pitch for flexibility is still set against the shift in the burden of proof within the Committee debates on how the data is assessed, namely, for reasons not to continue with the gradual pace of rate increases. That is in sharp contrast to the foreboding sense of caution that dominated the approach through the previous two years in sifting through the data for reasons to hesitate on a rate move.

It will certainly make the next Non-Farm Payroll print a week from this Friday that much more interesting, if only in the sense of exactly a year ago when the FOMC went into its June meeting with the same sense of high expectations for a summer rate hike. In that instance, of course, the hawkish-leaning FOMC was caught on its back foot by a surprisingly weak NFP print that undercut their confidence in the forecast.

For now the forecast being prepared for the June meeting is likely to be little changed. While the headline unemployment rate, at 4.4%, is already below the 4.5% rate projected for year-end, the base case expectation is for net job creation to steadily slow through the year, falling closer to perhaps around 120,000, to hold the unemployment rate more or less at its current range.

Along the same lines of thinking, the labor participation rate should at best stabilize if not drift down again in line with its demographic expectations of all those baby boomers retiring and women leaving the work force for good.

The market may see these labor market developments as further evidence of a weakening economy, but the Fed would tend to interpret the declining pace of job creation and participation rate as confirmation of a tight labor market settling into a trend just a bit below its longer run levels.

Nevertheless, some of the more recent input and color on the labor market is making for some interesting interpretations. In a recent Atlanta Fed survey of its regional businesses, for instance, Fed researchers found many companies reporting they were unable to find skilled labor, which was more or less expected; but instead of it leading to higher wages, companies were unwilling or unable to pay more or hire and train new workers.

Much of that hesitation was due to the lingering uncertainty of overall demand or how sustained the demand for their products will prove to be, in effect, the consequence of the elevated expectations, now fading, for a boost to growth and their products from the promised tax cuts, infrastructure spending and fiscal stimulus.

One interesting anecdote was about a company literally investing in lower levels of technology to fit the skills of their older but seasoned labor force rather than hiring and training new workers to match the latest in productivity-enhancing technology.

What’s more, the composition of the labor participation rates is not neatly fitting the models: for instance, those baby boomers who are supposed to be heading for retirement are instead sticking around, perhaps needing income to rebuild their savings for retirement. Meanwhile, the sharper declines in labor market participation are coming among men in their prime working age, a disturbing trend that suggests a major faultline in the level of incarceration and jail records, opioid addiction, and claims for disability insurance.

Translating into Weaker Inflation

These trends in the labor market are hardly in line with the expectations under even the most loosely interpreted slack-based Phillips Curve assumptions. Instead, across several districts, Fed officials are finding little appetite for raising prices, which seems to be reflected in the unexpected decline in the most recent PCE inflation measure, falling back to 1.6% in its most recent print. It may fall even further, rounding down to 1.5%, before it gets better.

Other anecdotal evidence, for instance, found many companies asserting they are literally forgoing expansion, at least for now, rather than trying to pass on their increased labor costs through higher prices. Another insightful feedback came from companies that were reluctant to raise prices for fear it could trigger the latest technological innovation that could quickly undercut whatever cushion they recouped on their profit margins.

Fed officials, for now, are mostly expecting the recent softness in price pressures to extend through at least the summer, only bottoming out somewhere later this year before resuming a gradual upward trajectory back towards the long-sought mandate-consistent levels around 2%.

That, of course, assumes a continued above trend growth and the tightening in the labor market that will, eventually, force a higher broad-based wage growth that, coupled to renewed optimism for a sustained economic growth, should underpin higher prices, especially in the service sector that is supposed to be far more immune to imported disinflation.

All of that is being factored into the anticipated June rate hike. But beyond June, in contrast to the heightened optimism among most Fed officials as recently as after the solid NFP in early May (SGH 4/5/17, “Fed: An On Track NFP”), our sense is that the upcoming data taken to be conforming this sort of forecasting assumptions will no longer keep the more dovish-leaning voting members of the FOMC on board with another rate hike as soon as September. Instead, the data across the summer, and the inflation data in particular, will need to be confirming the expected resumption in the upward trajectory in inflation.

What’s more, a temporary “bad optics” of seeking a rate rise amid flat or hardly rising inflation would be bad enough, but we also think more dovish FOMC members will start to worry once again that hiking rates in such a scenario may only harden self-fulfilling low or even falling inflation expectations.

On that note, a recent Atlanta Fed business survey included a question on their understanding of the Fed’s inflation target, and nearly 40%, across size and industry, believed the Fed was more likely to accept inflation below its 2% supposedly symmetrical inflation target; in fact, only one in four thought the Fed would accept inflation above the target.

That sort of evidence, if found to be more widespread and persistent, would translate into a far higher level of caution even the most determined Committee voter seeking to stick to the pace of rate tightenings, including the Chair, Janet Yellen. And that newfound sense of caution may make its way into the 2018 rate dot plots in showing some slippage in the rate projections for this year.

Indeed, if the inflation data over the coming months fails to stabilize and turn north, even if only modestly, we would expect much of the policy messaging by a mix of Fed officials to turn more dovish through the last half of the summer on the near-term prospects for a rate hike, with the risk of entrenching low inflation expectations chief among the reasons cited.

A Political September StormĀ 

One last point to factor into the rate pricing calculations for the Fed’s September meeting, and really, through the rest of the year, is the likely impact of the ongoing travails in the White House and the difficulties the Republican Capitol Hill leadership are running up against in passing the key legislation of the Trump economic agenda.

First, while there was certainly no shortage of chatter about impeachment in the whirlwind of political bombshells last week, most of which was self-inflicted by Trump himself (SGH 5/17/17, “US: The Impeachment Tail Risk”), we see little to no risk the political turmoil will linger in its intensity to preclude the anticipated Fed rate hike at the June meeting in three weeks’ time. If it did, we all probably have more to worry about than President Trump’s fate in the politics of an elongated impeachment process.

But second and further out, we do expect the political risk and general headlines of mayhem to weigh on the Fed’s near term rate path soon after Congress returns from its long August recess (SGH 4/21/17, “US: Healthcare, Tax Reform, and the CR”).

In September, we expect the political pressures and harsh headline shocks to become even more elevated, with little prospect the Republicans on Capitol Hill will be able to write and pass the 12 spending bills necessary for the FY2018 budget year that begins October 1.

That means yet another shutdown showdown is likely in the last half of September, as Capitol Hill scrambles to pass yet another Continuing Resolution or partial Omnibus to avoid shutting down the government for lack of funding. Somewhere in the mix, Congress will also need to pass a bill to increase the federal debt limit.

And if that were not enough, the markets will have a far better sense of the prospects for tax reform by September, and what form a final version of tax cuts the legislation might take before year-end, if indeed, it is to pass at all this year.

At minimum, the politics on Capitol Hill is going to make for a backdrop of volatility for a FOMC mid-September meeting when a rate hike might be on the table. We think, on the margin, that political noise is only going to add to the sense of caution among a majority of the FOMC on a rate hike, especially if as we noted, inflation is still coming up short by the time of the meeting.

Further out, however, we might add that even without a Trump reflation boost — and most of the FOMC’s latest rate dot projections are not factoring in a fiscal stimulus at all in their otherwise still hawkish looking upward rate assumptions — the Fed’s base case forecast still projects an above trend growth and an eventual rise in inflation back to its 2% target next year.

So even if the Trump budget and tax cuts fall well short of elevated expectations, the Fed has every intention to resume its gradual trajectory of raising rates and, by early next year, to have pushed the fed funds rate into a neutral range, thought to be somewhere around a nominal 2%. That will remain in place even with the start to the balance sheet normalization later this year, assuming of course, the economy stays the course on the forecast.

On balance then, a December rate hike is probably still in the hamper, with or without the balance sheet factor, or a likely pause in September.

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