The Federal Reserve will nudge rates 25bp higher this week. This will not end the policy tension among FOMC members. How will that unfold in 2017? My expectation is that whereas 2016 began with excessively high expectations for rate hikes, 2017 will be the opposite. My tendency is think that the risks to the Fed’s median forecast of 50bp of rate hikes in 2017 are more weighted to the upside than the downside. Beware then of a more aggressive than expected Fed.
The FOMC statement represents a compromise position. Broadly speaking, some policymakers rely on earlier paradigms calling for preemptive policy action as the economy heads toward estimates of full employment. Another group questioned those estimates given the apparent decreased sensitivity of inflation to unemployment in addition to risk management concerns at the zero lower bound.
Slower growth, an uptick in the labor force participation rate, and low inflation in 2016 lent support to the latter group, keeping the Fed on the sidelines since last December. Support from the data, however, has waned.
To be sure, incoming data does not entirely resolve the debate. On one hand, the unemployment rate plunged 0.3 percentage points in November to 4.6 percent:
This is below the range of the longer-run central tendency (4.7 – 5.0 percent), sufficient to prompt a preemptive rate hike in December without dissent.
Still, unemployment continues to decline in the absence of widespread wage or inflationary pressures. Wage growth declined in November:
and the October read on inflation was tepid:
Consequently, we shouldn’t be surprised by a modest downward revision to the Fed’s longer-run estimate of unemployment. Moreover, measures of underemployment remain elevated, suggesting that labor slack remains even near estimates of full employment, allowing for unemployment to dip below those estimates without much concern. These factors provide breathing room to maintain a slow pace of rate hikes of 50bp in 2017 implied by the Fed’s Summary of Economic Projections.
But job growth continues to exceed estimates of that necessary to exert downward pressure on the unemployment rate. Plus, temporary help employment is picking up, suggesting that broad employment growth will accelerate as well:
Incoming data indicates the Fed should place higher weight on upside risks to the medium run growth forecast. The Institute of Supply Management’s positive manufacturing report for November adds to the evidence in the third quarter GDP report that the sector’s inventory correction process is drawing to a close. The non-manufacturing counterpart also gained traction, including a sharp rebound in the employment component. Finally, the third quarter GDP number – a respectable 3.2 percent – might be underestimating economic strength. Gross domestic income (GDI) jumped a whopping 5.2 percent during the quarter.
And then there is the fiscal picture. Fed policymakers will maintain a careful approach to that topic – see New York Federal Reserve President William Dudley and Chicago Federal Reserve President Charles Evans here. But the prospect of wider fiscal deficits should tilt the balance of risks toward a faster pace of rate hikes as 2017 progresses.
Altogether, whereas in late 2015 the economy passed through an inflection point that derailed expectations for 100bp of rate hike, the economy looks to be hitting in the opposite infection point as 2016 draws to a close. That suggests that the central tendency of the Fed’s rate projections will prove to be too low this year.
In other words maybe, just maybe, this is the year the economy starts to feel “normal.” Rather than the Fed moving closer to the markets, the markets will move to the Fed.
Bottom Line: The Fed will hike rates this week; the unemployment drop will give added weight to case for a preemptive rate hike. They will play it close to the vest regarding future policy; although the stars are beginning to align for stronger growth next year, this represents more of a risk than a reality. Expect Federal Reserve Chair Yellen to emphasize that policy is data dependent.