Fed Watch: Jobs Data Keeps Hawks Sidelined

Tim Duy:

Jobs Data Keeps Hawks Sidelined: Federal Reserve hawks face an array of labor market data that threatens a key pillar holding up their policy view. That pillar is the assertion that monthly nonfarm payroll growth over roughly 100k will soon force unemployment far below the natural rate, thus placing the US economy in grave danger from inflationary forces. By this view, the decline of unemployment long ago justified further rate hikes. Hawks failed to anticipate that the unemployment rate would flatten out at 5 percent despite steady payrolls growth. This outcome does not fit in their worldview. Fundamentally, they were supply-side pessimists. The recent strength in labor force growth suggests their pessimism was sorely misplaced and undermines their argument for immediate rate hikes. The key elements of the FOMC - the permanent voters - now stand as supply-side optimists and are prepared to hold rates at current levels through the next meeting, and perhaps even longer. A December rate hike is still not a foregone conclusion. 

In recent speeches, Federal Reserve Chair Stanley Fischer appears to be now fully under the sway of Fed doves. Fischer's take on the employment report, from his speech this weekend:

Despite the strong job growth, the unemployment rate, at 5 percent in September, has essentially moved sideways this year as individuals have come back into the labor market in response to better employment opportunities and higher wages. As a consequence, the labor force participation rate has edged up against a backdrop of a declining longer-run trend owing to aging of the population. This increase is a very welcome development.

Four charts deserve attention here. First, "strong job growth:

Second, the unemployment rate has "moved sideways":

Third: "higher wages":

Fourth "labor force participation has edged up":

Overall, the October employment report justified the FOMC's decision to hold rates steady in September. The reasoning, according to Fischer:

But with labor market slack being taken up at a somewhat slower pace than in previous years, scope for some further improvement in the labor market remaining, and inflation continuing to run below our 2 percent target, we chose to wait for further evidence of continued progress toward our objectives.

The Fed sees that demand-side policy triggers a supply side response, and consequently does not want to risk leaving millions in the ranks of the unemployed (and remaining workers with sub-optimal wage growth) with a premature tightening of policy. Moreover, the lack of substantial inflationary pressures continues to the bedevil the hawks. As Fischer notes, inflation expectations remain in check, or, if they have moved, have drifted down. And while inflation has indeed edged up in recent months, it remains below target:

 

And I would argue that much of the rise in inflation was attributable to January's gain:

Fischer also undercuts the hawks' argument that preemptive hikes are necessary because without them the Fed will fall behind the curve:

But since monetary policy is only modestly accommodative, there appears little risk of falling behind the curve in the near future, and gradual increases in the federal funds rate will likely be sufficient to get monetary policy to a neutral stance over the next few years.

The key is that he sees policy as only modestly accommodative - a view that follows the Fed's epiphany on the persistence of a low natural rate of interest. Hence no massive catch-up would be needed even if future conditions require a faster pace of rate hikes.

I suspect that the hawks, now derailed by the employment data, will further pivot toward financial stability as they argue for a more rapid reduction of financial accommodation. Here too, however, Fischer is prepared to meet them head on. From last week:

Let me briefly mention a second reason for worrying about ultralow interest rates: The transition to a world with a very low natural rate of interest may hurt financial stability by causing investors to reach for yield, and some financial institutions will find it harder to be profitable. On the whole, however, the evidence to date does not point to notable risks to financial stability stemming from ultralow interest rates. For instance, the financial sector has appeared resilient to recent episodes of market stress, supported by strong capital and liquidity positions.

Overall, sounds to me that Fischer now embraces the intellectual framework pushed for over a year by his colleague, Federal Reserve Governor Lael Brainard. This likely is true also of all the permanent voting members. Within the context to the Board's current framework, the hawkish Fed president can do little more than squawk.  

Bottom Line: A November rate hike remains dead. We have two labor reports until the December meeting. A continuation of recent trends would leave a rate hike at that meeting in doubt. Odds favor that meeting currently, but it is not a foregone conclusion. The doves are supply-side optimists. They want to let this rebound run for as long as possible. And remember, those closest to Federal Reserve Chair Janet Yellen are now those that inhabit the halls of Constitution Ave. Be wary of the words of hawkish Fed presidents; they have been very misleading this year.