Fed: Inflation and the Near Outlook

Published on June 5, 2017

The June 13-14 Federal Open Market Committee meeting is just over a week away, and it looks likely to frame the near policy path on both rates and balance sheet normalization through probably the rest of the year.

*** The FOMC is near certain to lift rates to a 1%-1.25% target Fed funds rate. There is likely to be some slippage in the inflation projections, and a downward drift in the 2017 rates dot plot, but not enough to move the median off three hikes, or one more after June. Renewed concerns over the persistence in low inflation is straining the current consensus, leaving the door ajar for a pass on a September rate hike, which we think likely. But unless inflation expectations begin to fall, the FOMC will stick to its assumptions a still tightening labor market will, in time, push inflation towards mandate-consistent levels, which will keep a December rate hike in play. ***

*** We in fact don’t really sense much FOMC passion for a September rate move, at least in part due to a greater focus to get the portfolio normalization underway. And on that front, the FOMC made remarkable progress at its May meeting. In particular, the well-crafted staff-proposed compromise for a small initial cap to the maturing assets allowed to run-off with a pre-set ladder of quarterly increases went a long way to bridging the somewhat conflicting objectives for a predictable, passive reduction on auto pilot and the activist ambitions to retain policy discretion in turning to the balance sheet in case of a “marked deterioration in the economic outlook.” ***

*** That progress on the balance sheet plans should clear the way for the FOMC to “augment” the September 2014 Exit Principles and Plans as soon as the June meeting, or barring that, the July meeting, which would allow Chair Janet Yellen to brief Congress in her July Humphrey Hawkins testimonies. Under the sequencing taking shape, the FOMC would then follow through at the September meeting with what will be well telegraphed implementation details for an end to the reinvestment policy in the fourth quarter this year, perhaps as soon as October, and which should get the Fed out of reinvestments altogether by the end of 2019. ***

The September FOMC meeting could also be the first attended by the Trump Administration’s highly likely nominees to the Board of Governors, Randal Quarles and Marvin Goodfriend. We have not picked up on anything that would suggest their nominations will not be announced soon, and both will be easily confirmed by the Senate.

In addition, we understand Robert Jones, a recently retired President and CEO of the Indiana-based Old National Bank and a former Board member of the Federal Reserve Bank of St. Louis, is high on the list to fill the slot set aside for a community banker.

The NFP and a Still Tightening Labor Market

While we have been slashing the odds of a September hike now for weeks (see SGH 5/22/17, “Fed: A September Pause”), we were frankly a little surprised by the market reaction to Friday’s Non-Farm Payrolls print, as it was not nearly as bad as the reaction would suggest, and Fed staff are almost certainly going to be interpreting it as generally indicating a still tightening labor market in their preparations for the FOMC meeting next week.

Job creation did slow in May to 138,000 and the previous two months were both revised downward by 66,000, marking a rather gentle downward drift in the pace of job creation to an average 162,000 jobs a month since the turn of the year, compared to around 187,000 a month in 2016. The participation rate likewise took a slight dip to 62.7% from 62.9% in April.

But both have long been expected to be slowly declining and already built into the forecasting models. Job growth has been slowing really since the summer of 2014, a trend wholly expected and built into the forecasting models for an economy so deep into an expansion. And again, any job creation above the 100,000 a month mark or so is a net add, steadily removing the last of slack around the outer edges of the labor market.

The dip in the participation rate was not as much of a surprise as the brief upticks in participation last year despite the downward demographic trend line. It did account for most of the dip in the headline unemployment rate to 4.3%, which across the Fed, is seen as below its longer run levels. And even there, with so much of the decline in the under 25 age bracket, the print could be simply reflecting what a pain it is to seasonally adjust the data for the end of the school year.

On that score, the U-6 rate fell by quite a bit in May, to 8.4% from 8.6% in April, indicating to the Fed that as much as they are keeping an eye on tight labor markets exerting upward pressure on wages, there remains a fair degree of “hidden slack” in the US labor market.

And on wages, while the market commentary bemoaned the lack of stronger wage growth with Average Hourly Earnings coming in at 2.5%, for the Fed, it still marks steady, if not solid wage gains, however tepid the pace may seem. Indeed, most Fed estimates are not really showing broadly-based wage growth until the end of this year and early next as the very last indication of a healing labor market.

As we wrote previously, the labor market is certainly going through an unusual dynamic, much of it seen as being driven by the very nature of the slow recovery and the psychology that goes with it. Fed economists may present models underscoring “downward nominal wage rigidity” or “pent up wage deflation” (see SGH 1/19/17, “Fed: On the Near Policy Path”), but translated into English, it means both employers and employees have been reluctant to offer or demand wage increases after the shock to demand and jobs of the financial crisis nearly a decade ago and the tepid growth and political uncertainties ever since.

For many of those more prone to worry, the shape of what’s to come for the US labor force is threatening to stall into a Japanese style struggle to achieve any sustained waged growth even amid a record low unemployment. For these, the ominous threat of secular stagnation, or a prolonged state of a low growth, low inflation regime looms on the near horizon.

Inflation Expectations Will Be Key

But the bet in the Fed forecasts is a reassuring reversion to the mean, with enough high pressure on labor demand that employers will finally relent and be forced to offer training and rising wages to attract and keep their employees.

That same assumed reversion to an eventual equilibrium is very much at the heart of how the Fed is — for now — forecasting the inflation trend line and reacting to the dip in the various measures of inflation in the last few months.

Most Fed officials have stuck to the consensus messaging that the unexpected dip in price pressures this spring is transitory and will, in time, give way to a steady rise in inflation towards its mandate consistent levels on either side of the symmetrical 2% inflation target; the recovery in global growth and the above trend growth in the US driven by the continued tightening in the labor market will provide a steady upward cost-push on prices.

The Phillips Curve may be flattened, but the assumed linkage that is the cornerstone of every slack-based DSGE forecasting model will kick in unless the laws of physics have been rewritten.

Several Fed officials like Governor Lael Brainard or St. Louis Fed President James Bullard have already put markers down that the persistence in low inflation is elevating their concerns over the merits of continued rate hikes after this June. Other equally dovish-inclined Committee members share their concerns.

And since it is our sense that Fed forecasters are generally not expecting to see the desired uptick in inflation until deeper into the year, we had thought the bad optics of a hike in September amid what is likely to be ambiguous at best inflation data would be enough to put a pause in rate normalization on the table at the September meeting.

But whether it translates into a dovish turn to a pause must be framed against the back story of firmly held expectations across the Fed system that an inertial inflation is more likely than not to slowly grind upward for at least a year or more before finally reaching that 2% mark. Indeed, it is a hard battle to dislodge entrenched assumptions, and if most Committee members were forced to choose between the rate implications of an ever tighter labor market versus a still dormant inflation, most would probably opt for the former over the latter.

What’s more, as this testing of the Phillips Curve trade-off looms, it is important to note the one development that would truly and quickly align the FOMC consensus on rates in the run up to September is any signs of further declines in inflation expectations across the survey and market measures. Even a whiff of continued deterioration will drive hawks and doves alike to a probable pause in the pace of rate normalization.

So on the score, whether the messaging of Fed officials over the course of the summer and at the Jackson Hole conference in late August turns on inflation expectation concerns or reaffirms the faith in data conforming to the eventual expected rise in inflation will be crucial stage setters to framing rate expectations going into the fall.

And if the persistence in low inflation looks likely to be extending to year-end and beyond, it would inevitably put a presumed resumption of rate policy normalization in December in doubt. It would also mean for Chair Yellen and the FOMC, not only a tougher call on whether or not to hike rates in December, but whether the conceptual framework driving policy normalization needs a painful reassessment.

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