Thursday, July 30, 2015

The Fed: How much is "some"?

There were only minor tweaks to the FOMC statement this morning when compared to the June statement.  In short the Fed expects to be starting to raise interest rates after it has seen “some further improvement in the labor market”.  Anything less than that would have been inconsistent with Fed Chair Janet Yellen's recent Humphrey-Hawkins testimony to Congress and any number of recent comments from other FOMC members.

The only question now is exactly what “some further improvement” looks like.  Comments earlier in the statement about “recent solid job gains and declining unemployment” and “underutilization of labor resources has diminished since early this year” provide helpful guidance.  It seems a continuation of monthly payrolls gains of over 200k per month and a continued drift lower in the unemployment rate may well be sufficient for interest rate normalisation to begin.  Of course upcoming prints on employment costs and GDP will also add colour to future deliberations.

It might seem a tad trivial that after having prognosticated on interest rate normalisation for so long that all that matters now is the next couple of payroll numbers – but that would belie the significant improvement in the US labour market over the last seven years. 

It’s important not to forget the ongoing uncertainties.  Why has labour productivity growth underwhelmed since the great recession?  How much of the decline in the participation rate is structural and how much is cyclical?  What are the levels of potential growth, the natural unemployment rate and the neutral interest rate? 

We (including the FOMC) won’t know the answers to those questions for some time.  Even Janet Yellen in a recent speech admitted she didn’t know why recent productivity growth was so low.  But not knowing the answers to these questions shouldn’t delay the start of the normalisation process, indeed we will soon be at the point where the risk of tightening too early is being overtaken by the risk of going too late.  

So barring a significant downward data surprise, we expect “lift-off” in September and a very gradual pace of rate hikes thereafter.