Fed steps over an economic soft patch to raise rates again

By Sally Sargent, Senior Managing Director, Wealth Management

Discover how the Fed was not swayed by weaker-than-expected first quarter data and suggests that the domestic job market is healthy enough that inflationary pressures might not be far behind.

On June 14, 2017, the Federal Open Market Committee (FOMC), led by Federal Reserve Chair Janet Yellen, raised the U.S. Federal Reserve’s benchmark federal funds rate by 0.25 percent to a range of 1.00 percent to 1.25 percent. The recent hike marks the fourth one-quarter point increase of the current rate hike cycle that began in December 2015. Unlike the March 2017 rate hike, which was accompanied by several weeks of significant messaging efforts by various Fed officials ahead of the decision, today’s hike has been more widely anticipated for a longer period of time. According to Bloomberg’s World Interest Rate Future Implied Probability model, the market-implied odds of Fed rate hike in June were at least 60 percent since April 24, 2017. Just two weeks ahead of the March rate hike, the market implied the probability of a hike for the March meeting was only about 35 percent.

In making their decision to hike the U.S. benchmark rate by a quarter percent for the third time in seven months, Fed policymakers seemed to peer around a recent batch of weaker-than-expected data from the first quarter. Several important economic data releases fell short of elevated expectations in recent months including data for consumer sales, consumer spending and the May non-farm payrolls report. FOMC participants, however, don’t appear swayed by this bout of softness, signaling in minutes from their March meeting that first-quarter weakness was “likely transitory.”

Consumer data series and the Labor Department’s monthly payrolls number are among the most widely covered economic releases. As such, they can drown out important signals from other areas of the economy. In a recent call with clients, BCA Research Global Strategist Caroline Miller pointed out that strong readings from the Institute for Supply Management (ISM) Manufacturing Index and various consumer and business confidence readings persisted in the first five months of the year. Miller further made the case that the ISM Manufacturing Index (a proxy for U.S. manufacturing expansion and contraction) tends to lead commercial loan growth by six to twelve months. In other words, if the domestic manufacturing sector is expanding, historical precedent suggests a related expansion in credit creation several quarters down the road.

So, Chair Yellen and her FOMC colleagues find themselves in a scenario with what appears to be an expanding manufacturing base, elevated consumer and business confidence and a headline unemployment rate of 4.3 percent - the lowest level since February 2001. As highlighted in previous versions of this series, the exceptionally low levels of official employment witnessed in recent years contradict a generationally low labor force participation rate which has bounced between 62 percent and 63 percent for nearly four years. This is most likely a structural issue rooted in demographic trends, mismatches between education and employer needs, etc. Yet, from a cyclical perspective, an argument could be made that the U.S. economy might be approaching so-called “full employment” or may even have reached a level of “over-employment.” This argument would hinge on a simple observation that the domestic unemployment rate of 4.3 percent from the May payrolls report is currently well below the FOMC’s most recent estimate of a 4.7 percent natural rate of long-term unemployment. The Fed’s official measurement is referred to as its non-accelerating inflation rate of employment or NAIRU, a level of unemployment below which inflation is expected to rise. Currently, there are fewer unemployed Americans as a percentage of the domestic labor force than Fed policymakers on average deem suitable for stable inflation. Or, in other words, the cyclical state of the domestic job market is healthy enough that the Fed’s models predict a future increase in inflation.

U.S. Wage Inflation and Employment Slack 

In many previous cases throughout history when unemployment dipped below the Fed’s natural rate of long-term unemployment, inflationary pressures were not too far behind. So far, we haven’t seen much inflation, as the most recent readings for the U.S. personal consumption expenditure core price Index and year-over-year growth in average hourly earnings both remain tame at 1.5 percent and 2.5 percent, respectively. Yet, the potential for a scenario where upward wage pressure emerges along with increases in broad-based inflation and a general “overheating” of the U.S. economy is likely to be front and center in the minds of Federal Reserve policymakers. The chances for an inflationary scenario could be further heightened if the Trump Administration and GOP-controlled Congress implement any type of fiscal stimulus in the form of corporate tax cuts, personal tax cuts and or deficit-financed infrastructure spending. 

From the Fed’s perspective, the distribution of risks might have shifted from normalizing interest rate levels too fast (and thus choking off economic growth), to normalizing too slow, thus subjecting the economy to a period of inflationary pressure potentially amplified by future fiscal stimulus. So-called quantitative easing (or large scale bond-purchases) aside, the Fed’s primary monetary policy tool is its ability to change the benchmark federal funds rate in response to economic over-expansions and contractions. Its ability to cut interest rates in the event of a future economic over-expansion would be curtailed if the benchmark rate remains too low for too long.