Fed: The NFP Reaction Function

Published on February 5, 2016

A quick note on what we believe would be the Federal Reserve’s most likely takeaways from this morning’s surprisingly strong Non-Farm Payroll numbers, despite a downside miss on expectations for the headline figure:


*** While the odds for a March rate hike are still dimmed relative to a few weeks ago, the overall tone to today’s NFP print underscores why that much anticipated second rate hike is not entirely off the table six weeks or so from now. Perhaps more to the point, it certainly does not validate the market’s gloomy pricing that has erased almost all prospects of tightening for the entire year. ***


A Still Resilient Real Economy


First, it is always worth keeping in mind that for the Fed, what matters most is whether the signals that can be stripped out of the month to month noise tend to support the expectations and assumptions that are being penciled into the forecast. Adjustments are constantly being made along the way in the run up to the actual snapshot of projections prepared for the meetings of the Federal Open Market Committee, and on which they have to make a policy decision.


So with that in mind, the numbers this morning were across the board pretty much right in line with the forecasts: a resilient economy still generating a steady pace of jobs to underpin aggregate demand. Ignore the lower headline number and for that matter the modest downward revision to December’s out-sized gains since job creation is already largely expected to steadily decline towards a more sustainable 150,000 average through this year, and while maybe not all at once beginning in January, this morning’s number is in the right direction.


The big jump in the Average Hourly Earnings will obviously be bit of a surprise to the upside, but it is highly unlikely to be sustained. The larger point is that wages are moving in the right direction. The same logic would also apply to another uptick for the third month in a row in the labor participation rate. And despite the rise in the participation rate the headline unemployment rate still fell to 4.9%, which suggests that the lower pace of job growth is still strong enough to tighten up the outer slack in the labor market.


Indeed, perhaps the key to the Fed’s projections for this year lie in the upticks in wages and the participation rate as the best “conforming” evidence that a rising underlying core inflation rate should be evolving in line with the forecasts.


The March Rate Scenario


The March rate scenario will obviously depend on whether the data is still coming in along the lines suggested by the NFP this morning, and in particular, whether there is any give in the persistence of low inflation that is the primary restraint. But if the dollar and oil prices do stabilize in the coming weeks, it will do much in the way of lifting the downward siege on goods prices, and the Fed’s assumptions of an underlying core inflation around 1.7% or so will become more apparent in the data.


But in equal measure, perhaps even more so, much about March will depend on whether the market will indeed begin adjusting positions and pricing to the data rather than the fear-driven herding that seems to be dominating current market behavior.


That various Fed officials were offering more dovish-sounding reassurances earlier this week about an even slower pace of policy normalization was, as we noted in the report yesterday (SGH 2/4/16, “Fed: Tactical Adjustments, Same Strategy”), as much about seeking to rein in some of the excessively gloomy market sentiments as it was a reflection of potential adjustments in the policy path, the idea being to buy some time until there is a bit more clarity in the data.


As we also noted yesterday, the Federal Open Market Committee is not going to lose any sleep over not moving on rates in March since there is little immediate pressure to do so, if they need to wait until April or probably June they will.


But again, assuming the job engine does not falter, a March rate hike cannot be taken off the table just yet, nor can further rates hikes later this year in the long path towards policy normalization.

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