Monday, June 30, 2014

The labour market will be key to helping the Fed navigate the noise

It’s been very “noisy” in America lately.  The recent move higher in US inflation has largely been dismissed as “noise”.  Likewise the March quarter GDP contraction can be attributed to a confluence of one-off negative factors that belies the underlying trend improvement in the economy.  How’s the Fed to navigate its way through the noise?  Why, by focussing on the labour market of course.

Market participants are currently trying to ascertain the messages, particularly for monetary policy, of recent data showing that in the March quarter the US economy contracted at its fastest quarterly pace since the GFC recession, while at the same time most measures of inflation have nudged higher.

We buy the story that the March quarter growth number was an aberration (see post below).  That said annual average growth now seems likely to come in under 2% this year.  That lower growth has direct implication for the size of the output gap and the length of time it will take for pressure to emerge on resources and for generalised inflationary pressures to emerge.

At the same time data shows the annual rate of headline CPI inflation reached 2.1% in May.  The core index (excluding food and energy) rose 0.3% in the month to take the annual rate to 1.9%.  Sharply higher airfares was quoted by most analysts as the reason for the higher-than-expected increase in core inflation over the month and hence the comment that the number could be attributed to “one-offs” and “noise”.  That sentiment was given “Fed-cred” with Janet Yellen commenting in the post-FOMC press conference that “the data we are seeing is noisy” followed by “broadly speaking, inflation is evolving in line with the Committee’s expectations”.

It seems risky to dismiss the move higher completely, especially with a broad range of inflation measures now pointing higher.  Along with the core CPI the core Personal Consumption Expenditure (PCE) deflator, the Feds preferred inflation measure, is also heading higher, albeit from a lower base.  More telling is that key trend measures such as the annual rates of median and trimmed mean inflation are also heading higher.

The FOMCs comments about noise indicate they are not seeing anything in recent data to suggest a rise in generalised inflationary pressures.  I’ve long pointed to the labour market and, more precisely, unit labour costs as the key indicator to watch in that regard.

Future wage growth will be determined by the degree of excess capacity in the labour market. The conventional wisdom is there is plenty of it.  While the official measure of unemployment (U3) has fallen more rapidly than expected, at 6.3% it remains elevated by historical standards.

A broader measure of underemployment in the economy (U6) which includes people “marginally attached” to the labour market and those who work part-time “for economic reasons” also remains elevated at 12.2%.  Furthermore, the gap between the two (U6-U3) which averages 4.6 percentage points over the last 20 years, currently stands at 5.9 percentage points.

But you could also point to the recent drop in the unemployment rate of those who have been unemployed for just a short period of time (less than 27 weeks) to 4.1% as indicative of a declining pool of people whose skills are (arguably) the most relevant in the new post-GFC US economy and thus a labour market that is tighter than the other indicators suggest.

It seems to me there is certainly slack in the labour market, but the amount of slack is moot.  While there is uncertainty, the Fed will rely on labour market price signals (wages) to determine the spare capacity in the labour market.  While some measures of wage growth are heading higher, it’s the interaction with productivity and the resultant impact on unit labour costs (ULCs) that will determine the inflationary consequences. 

ULCs are highly volatile, but once (heavily!) smoothed display a nice fit with core inflation.  However, the Fed will not want to wait for ULCs to be heading higher before starting to remove the extraordinary levels of monetary accommodation.  Judgement will still play a critical role.

On balance it seems to me the Fed will still be pretty relaxed about both the growth and inflation outlook for a little while yet.  Risks arouind the consensus view that the Fed will be able to hold off until mid-next year still appear to me to be evenly balanced.

But we are still of the view that the next problem for the US economy and for markets to navigate is inflation. As it inevitably heads higher clear and unambiguous communications from the Fed will become even more critical.  That’s especially if they are prepared to wear higher inflation while the other part of their dual mandate, full employment, needs more time.