Friday’s NFP went some way towards easing the Fed’s downside concerns and to reaffirm the case for policy normalization.
If data continue to track the base case forecast, a second rate move could in theory come as soon as September.
More likely would be the prior template of a messaging reset between September and a rate move by December.
The Fed’s lowered rate projections and longer run neutral estimate will mean an even more flattened, elongated trajectory.
July 12, 2016
It is hardly surprising after Friday’s solid Non-Farm Payroll that some Federal Reserve officials began to revert back to hawkish-sounding rhetoric in their policy remarks this week, and others are sure to follow with near equal stress on upside risks in the run up to the Federal Open Market Committee’s July 26-27 meeting.
But the May misfire in the hawkish messaging right up to the eve of the confidence-shattering NFP in early June – since alleviated, who knew? – will make Fed officials wary of getting too date-specific or trying to again rapidly build up market expectations, which is probably a good thing since the market is rightly pricing no chance of a rate move in July.
*** That said, however, the trend lines in the NFP and recent data have eased much of the Fed’s earlier downside anxieties and have in fact boosted confidence in its slack-based policy framework. The Phillips Curve may be flattened, but the assumptions remain for a still tightening labor market and, eventually, higher inflation. The FOMC policy normalization consensus may be bruised by some internal doubts and battered by market and academic skepticism, but it still drives the near policy path. ***
*** The market is thus underpricing the odds of a Fed rate move as early as the September 20-21 FOMC meeting, with a higher probability of a rate move by the December meeting (this year that is). That assumes, as always, data continue to align with the Fed forecast. And while the overhang of Brexit risk and an excessive dollar appreciation remain as risk management factors, they are coming to be seen as a longer term risk rather than a near term reality in scale enough to deter a rate move. ***
*** If the FOMC consensus still remains to raise rates after a summer’s worth of data watching, a still largely inertial inflation may give the FOMC some tactical leeway on its timing. Even if the data and market conditions are there or nearly there in September, for instance, the FOMC could opt out of an elevated sense of risk management caution to let the data take the lead and to steadily built its messaging to steer market expectations for a December rate move, as it did in both the 2013 taper and the 2015 rates lift-off. ***
At the same time, the Fed’s pessimism on productivity and trend growth is bringing rate projections and the longer run neutral estimates ever lower, translating into an even more flattened, elongated trajectory.
NFP Mean Reversion Squared
Just about everyone, including the Fed, was expecting a respectable reversal of May’s disappointing Non-Farm Payrolls back to a higher albeit slowing pace of job creation in last Friday’s NFP print. Instead it was much more, a mean reversion squared, if you will.
It is, of course, a single print, and the previous two months were revised lower, underscoring how volatile the month to month data can be. But June’s 287,000 jobs, for a second quarter rolling average of 147,000 jobs month, fit neatly within the Fed’s own projections for a decelerating pace of job creation from the first quarter’s near 200,000 jobs a month.
The rise back to a 4.9% headline unemployment rate was likewise in line with month to month fluctuations of the main unemployment rate still at or near full employment. What’s more, the job growth was across nearly every sector of the economy, while May’s worrisome rise in part-time workers looking for full-time work was reversed with a decent decline in the broader U6 unemployment rate.
Fed officials will be especially pleased by the rise in the labor participation rate against its longer demographic downward trend, indicating there is still some slack that can be soaked up by drawing in the discouraged and longer-term unemployed. Average Hourly Earnings also saw an uptick to an annualized 2.6%, which portends well for a rise in the Employment Cost Index later this month, perhaps to 2.5% annualized.
The NFP, then, went some way for a majority of the FOMC towards taking out some if not most of the downside risks that had been darkening the outlook. Instead, the overall thrust of the recent data, and especially if reinforced through the summer, looks to the Fed as the sort of data one would expect in an economy at the cusp of full employment, which despite the overhang of global risks, is likely to see rising wages, and perhaps in time, higher business investment spending.
And following from that, however flattened the Phillips Curve may be, the Fed majority consensus remains that as long as the above trend growth holds, inflation is all but certain to be rising towards 2%, not falling, across the forecasting horizon.
The backdrop to that, to be sure, is the Fed’s resistant concessions to a lower trend growth and much lower estimates of the longer run neutral policy rate — and which could still fall lower still by September — that is flattening and extending the trajectory of its ever so gradual policy normalization rate path.
But that newfound realism on the persistence in a near zero effective real neutral rate does not necessarily preclude the arguments for a near rate hike, only the eventual pace and height of the rate trajectory as economic conditions evolve.
The pain and downward pressures of global low growth and low inflation are without question factors being penciled into the parameters of the Fed’s base case forecasting models. But their dominance in shaping policy decisions is for now, on the margin and a view among only a minority of the Committee, however vocal they may be.
Patience, then, is a virtue in the still fragile, slow but steady recovery, and caution is the key watchword of the policy normalization path. But it is tactical calculations that define the caution, not doubt or an abandoned policy normalization path. At least not yet.
The July Statement and a More Careful Messaging
If the NFP signals are replicated in the retail and other closely watched data later this month, it would suggest the FOMC statement at its July 26-27 meeting will retain the language signaling a continued expectation or bias to tighten ever so gradually in the long path of policy normalization. The propsect of a shift to a bias to ease or backing off policy normalization have for now been brushed aside.
There is also a chance the Committee may even opt to play down the Brexit uncertainties in the July statement. It would somewhat run against their instincts to keep all their options open unless forced to choose, but it would be one way to message their policy lean towards a rate move, potentially as soon as September.
This time round, however, a majority of Fed officials are likely to talk up the economic outlook and the conditions that would support a second rate hike, but they will religiously avoid getting too date-specific. With an inflation dynamic that even the more hawkish Committee members concede is still very inertial, the thinking this time is to let the data take the messaging lead on a next rate move.
Indeed, there is unlikely yet to be enough of a united Fed front in messaging that elusive second rate hike looms in the way there was a concerted communications drive in May to nudge market pricing higher in the run up to the June and July meetings. And in any case, successfully moving resistant market pricing will almost certainly need to include strong signals at the late August Jackson Hole conference, where this time Chair Janet Yellen is speaking.
Risk Management and a Template for a 2016 Hike
As the FOMC moves closer to its September 20-21 meeting, Chair Yellen and her closest colleagues will be well aware that Brexit risk, or general European political risk, could again be hanging over the Fed policy deliberations as it did in June.
The risk is not just of an immediate volatility in the aftermath of another UK or European shock. The more important risk that will have to be weighed in September is to what extent any persistent appreciation in the dollar could be just enough to further weigh on inflation or even press growth below trend? An ever more gradual pace of rate increases would begin to stretch the credibility of the base case for even attempting to “normalize” rates.
And another risk likely to feature in Fed remarks over the coming weeks and months is the big downshifts in global yields and deeply compressed term premiums. Equities and bonds both surging simultaneously is viewed by many Fed officials as an unstable equilibrium.
Under such conditions, a risk-averse FOMC may find itself leaning even further on the sense of caution that already deeply colors the Fed’s careful approach to rates policy.
As a result, the FOMC may find itself turning to the template used twice so far, in the run up to the December 2013 start to the taper and again in last year’s December rates lift-off: strong signals in September, backing off to reset expectations under a more unified messaging that follows the data to an eventual move in December.
Both of the previous moves were more by default than design, but it if worked twice before, a third time may still prove the charm.