Fed: Confirming and Conforming

Published on January 8, 2016

This morning’s Non-Farm Payroll was almost too good in bolstering the case for the base case rate path being mapped out by Federal Reserve officials since their December meeting decision to begin their long awaited policy normalization.

For one, the 292,000 jobs created in December is nearly twice the 150,000 a month the Fed is anticipating as an average monthly job growth this year. More to the point, we suspect that a solid pace of jobs growth, even if it should slow in the coming months as anticipated, will tend to tip the scales for the Federal Open Market Committee to conclude inflation is indeed likely to rise in line with its forecasts to warrant a second rate hike.

*** Inflation, rather than employment as in December’s first rate hike, is now the hurdle the FOMC needs to jump to a second rate hike. But our sense is that the hurdle just isn’t as high as the market may be assuming, in that the FOMC left itself plenty of policy flexibility by citing both “expected” and “actual” inflation in its monitoring of whether inflation is rising towards mandate-consistent levels. ***

*** If the domestic economy and the labor market continues to perform more or less in line with the central tendency forecast, even if rising inflation is not confirmed in the data but the inflation dynamics still look to be “conforming or evolving” in line with the underlying assumptions of the forecast for higher rising prices, the FOMC is more likely than not to raise rates again in March. ***

Echoes of July in the Minutes

The likelihood of a March rate hike or four hikes in the year may seem to be inconsistent with the very dovish feel to the December meeting Minutes, with the repeated concerns and anxieties over the persistence of low inflation.

But our sense is more of caution against assuming excessive dovish takeaways from the Minutes for the rate path. The Minutes did read very dovish, especially in the repeated concerns by “some” — the fingerprints of Chicago Fed President Charlie Evans are everywhere — over the risks in the persistence of low inflation.

But there is a certain dynamic to the Committee discussions that may account for the contrast between the dovish natures of discussions relative to the hawkish outcome in the policy decisions by the meeting’s end.

With it all but a foregone conclusion going into the meeting that the FOMC was highly likely to begin policy normalization, there was little point for a Committee majority in further making the case, say, by noting the upside risks however distant, or even laying out, yet again, the merits of a “sooner and slower” rate trajectory that was in fact the main case for the December first rate hike.

Instead, most of the discussion time and ink in the Minutes was invariably left to the on the losing side of the policy debate. The December meeting, in this sense, is an echo of the July meeting Minutes, which read far more dovish than the actual voting member decision, which was to begin the messaging campaign for an (aborted) rate hike in September.

We think the main point of contention in the December meeting may have been where to draw the line, in whether the Committee should wait to see actual confirming evidence of rising inflation in the coming data before continuing with its policy normalization, or whether it could safely proceed if the all the data, not just the price measures, look to be indicating a behavior in the inflation dynamics that is conforming to the underlying expectations in the forecast. Only an English major may appreciate the distinction between confirming and conforming evidence, but we suspect the balance of the Committee leans to the latter.

Protecting a Long Trajectory

In other words, even if the expected higher inflation is not yet showing up in the data, if the Committee majority is confident the transitory effects of the strong dollar and weak oil prices will indeed be steadily slipping out of the data through the year, and that those hotly debated Phillips Curve linkages between employment and inflation will eventually show up in the data, on balance, the Committee will vote to raise rates again as soon as the March meeting.

Indeed, the four rate hikes this year is already incorporating a very gradual rate path, which is half of the measured path of 2004-2006. If there are substantial delays in the expected base effects of the transitory oil and dollar effects in the coming months, it could slow the pace of rate hikes.

But if the economy and job creation continues along a path laid out in the central tendency forecast, the FOMC is more likely than not to feel it is more prudent to stick to its rate path of a second hike in March and four rate hikes through the year. The desire to protect itself against the potential need to raise rates so rapidly it risks dislocations in the financial markets or a derailment in the recovery is paramount.

That need to protect a long trajectory (see SGH 3/6/15, “Fed: Getting There”), in the context of overall financial stability, is a theme we think may become more prominent in the public messaging in the run up to the March meeting.

A Solid NFP Print

It is against that backdrop that this morning’s Non-Farm Payroll print should be read. The headline 292,000 jobs print was an out-sized upside miss to expectations around the 200,000 mark, and the revisions to the previous months pushed the year-end three month average up to 284,000.

The headline unemployment rate did stay at 5%, but because it was mostly on the slight gains in the labor participation rate by a tenth to 62.6%, the Fed will probably welcome that more than a further drop in the headline rate since it would look to be confirming the anticipated drift of sidelined workers back into the labor force.

Wage growth did admittedly disappoint, with average hourly earnings dipping a penny. But here again, there is less bad news than meets the eye in the headline, in that steadily rising wage growth is not really expected until later through this year. And in any case, while the month on month wage gains fell flat, Fed officials will no doubt point to the year on year growth in earnings rising to 2.5% in 2015 from the closer to 2% levels since the recovery began in 2010.

It may seem hard to reconcile the robust job growth of the fourth quarter with the lower growth projections of the latest GDP forecasts, unless like the Fed, you don’t really pay that much attention to the GDP prints compared to the monthly jobs numbers.

And looking ahead, while it may seem out of place amid the current market volatility over China and the exchange rate uncertainties, the Fed remains relatively more sanguine about the global growth outlook. Some slowdown in China growth is already factored in the 2.4% median U.S. growth forecast for 2016, and the Fed, for now, sees little reason to assume a hard landing in Chinese growth below 4% or less.

Along the same lines, the Fed remains relatively upbeat on modest growth prospects in both Europe and Japan, and whilst they expected it to come sooner, they continue to see the renewed drops in oil prices as a further boost to global aggregate demand.

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