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
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
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
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.