The US Federal Reserve: it’s nearly time
In the US a number of negative influences (poor weather, a port strike) saw the economy post a small contraction in growth in the first quarter of the year. There has therefore been much focus on the extent to which growth would recover, especially in light of the Fed’s continued signalling that an interest rate increase remains likely this year. The data has started to improve as the quarter progressed: construction activity has bounced back, consumers have reached for their wallets again and jobs growth has moved back to a more solid trajectory.
On the inflation front, most measures of inflation and wage increase are off their lows but going nowhere in a hurry. Importantly it’s the Fed’s preferred measure of inflation, the core personal consumption expenditure deflator (core PCE deflator) that remains softest of all. That said, with just about every other inflation indicator pointing higher, the Fed will have reasonable confidence PCE inflation will head higher also in time. And it remains the case that they won’t wait for inflation to get to 2% before tightening – they just have to have confidence it will get there.
We continue to keep a close eye on labour productivity growth which continues to underwhelm, as it has since the Great Recession. The reasons for that are not clear: it could be cyclical, structural or even a measurement problem. Even Janet Yellen, the Chair of the US Federal Reserve, admitted in a recent speech she is unsure of why productivity remains low. The problem is if low productivity is real and structural, it means potential growth is lower and even current growth of below 3% may be inflationary, especially as unemployment reaches its natural rate.
US productivity and unit labour costs
Annual % change
Source: US Bureau of Labor Statistics
The September meeting of the Federal Open Market Committee (FOMC) looks odds on to be when they decide zero interest rates are no longer appropriate in the US. That assumes the data continues to improve. Weaker data will see that pushed out to December.
And we can’t completely dismiss the possibility the Fed doesn’t hike rates at all. But of course that means when the time comes for new stimulus as the economic cycle inevitably turns down, the only option open to the Fed may be a fourth round of quantitative easing.
We think that the Fed should just get on the job so that markets can focus on the bigger issue of the likely pace and extent of interest rate increases. We continue to expect that pace to be slow and gradual. Indeed, a September hike may be the only increase year. And we wouldn’t discount the possibility of them doing something different to reinforce the gradual nature of future rate hikes. There’s nothing that says they need to hike rates in lots of 25 basis points. Perhaps they hike in lots of 12.5 bps? Some of my colleagues think that’s a silly idea, but it’s a different world folks!
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