The US economy is an island of mediocre tranquility in the midst of the stormy sea of the global economy. Tranquil enough to keep the Fed eyeing its first rate hike despite the surrounding storm, but sufficiently mediocre that they feel no reason to rush into that hike. As such, the Fed will remain on the sidelines until the forecast points toward sunnier skies. Uncertainty from Greece and China are likely raising the bar on the domestic conditions that would justify a rate hike.
Monetary policymakers are increasingly convinced that the first quarter weakness in US data was largely an aberration. From the minutes of the June FOMC meeting:
In discussing how to interpret the reported weakness in real GDP during the first quarter, participants considered alternative estimates of real economic activity based on various data-filtering models maintained by Board and Reserve Bank staff. These models yielded a range of estimates, but, overall, they suggested that real activity in the first quarter was likely stronger than the then-current official estimate of real GDP. Some participants indicated that the higher alternative estimates seemed more consistent with the increases in real gross domestic income and private domestic final purchases in the first quarter as well as the strength in employment and hours worked.
Effectively, policymakers believe the first quarter dissapointment was largely noise; the underlying pace of growth remained fairly consistent with recent trends. Moreover, data since the June meeting suggests the Fed's confidence is warranted. Via the Atlanta Federal Reserve:
And while they believe risks to the economy are fairly balanced:
While participants generally saw the risks to their projections of economic activity and the labor market as balanced,...
they aren't all that comfortable with the outlook:
...they gave a number of reasons to be cautious in assessing the outlook.
One group is concerned with the still too slow progress toward their goals:
Some pointed to the risk that the weaker-than-anticipated rise in economic activity over the first half of the year could reflect factors that might continue to restrain sales and production, and that economic activity might not have sufficient momentum to sustain progress toward the Committee's objectives. In particular, they were concerned that consumers could remain cautious or that the drag on sectors affected by lower energy prices and the higher dollar could persist.
Another thought growth would come roaring back:
Others, however, viewed the strength in the labor market in recent months as potentially signaling a stronger-than-expected bounceback in economic activity.
I suspect the last labor report - with its ho-hum headline NFP number and downward revisions to previous months - took some of the steam out of that argument. Some were looking abroad for problems:
Several mentioned their uncertainty about whether Greece and its official creditors would reach an agreement and about the likely pace of economic growth abroad, particularly in China and other emerging market economies.
And who knows what is going on with productivity? From the minutes:
Other concerns were related to whether the apparent weakness in productivity growth recently would be reversed or continue. On the one hand, a rebound in productivity growth in coming quarters might restrain hiring and slow the improvement in labor market conditions. On the other hand, if productivity growth remained weak, the labor market might tighten more quickly and inflation might rise more rapidly than anticipated.
And on and on it goes. Consumer spending has good fundamentals, but seems too weak relative to expectations. Housing markets are looking up, but remain historically soft and plagued by problems such as tight underwriting. Manufacturing is soft, but autos are strong and so too is the service sector. Labor markets are making progress toward goals, but slack remains.
On labor markets, however, there does seem to be a growing conviction that we are coming close to full employment:
...Several other participants indicated that, in their view, labor market slack had already been largely eliminated.
The ongoing rise in labor demand appeared to have begun to result in a firming of wage increases. Recent readings on the employment cost index, hourly compensation, and average hourly earnings of employees suggested some acceleration in wages. According to business contacts in a number of Districts, many firms looking for new workers said they had been raising wages selectively to attract them; some had also begun to raise wages more generally...
But even this bright spot is not so bright:
...However, several participants pointed out that, even with the recent upturn, wage increases remain subdued...
Inflation remained low, but some participants offered evidence of better numbers in the future:
Participants discussed how the incoming information regarding inflation influenced their expectations for reaching the FOMC's 2 percent inflation objective over the medium term. Total PCE inflation continued to run below the Committee's objective. However, participants noted that the apparent stabilization of crude oil prices and the foreign exchange value of the dollar would reduce the downward pressure on inflation from falling prices of energy and imported goods. Core PCE price inflation, as measured on a 12-month change basis, had slowed slightly from an already low rate. However, several participants pointed out that the 3-month change in that index had firmed recently, signaling some improvement in the inflation outlook. In addition, some cited alternative measures of inflation, such as the trimmed mean and median consumer price indexes (CPIs) and the trimmed mean PCE, which continued to run at higher levels than overall PCE inflation.
The upshot for policy:
Most participants judged that the conditions for policy firming had not yet been achieved; a number of them cautioned against a premature decision. Many participants emphasized that, in order to determine that the criteria for beginning policy normalization had been met, they would need additional information indicating that economic growth was strengthening, that labor market conditions were continuing to improve, and that inflation was moving back toward the Committee's objective.
In short, the US economy is locked into the most mediocre of equilibriums. Consistent if uninspiring growth:
job growth sufficient to gradually eliminate labor market slack:
but not fast enough to rapidly raise wages
or push inflation back to or beyond target:
Nothing to panic about, nothing to write home about. The general improvement and proximity to full-employment points toward a rate hike this year so that policy is leading any incipient inflationary pressures, but they need see more progress to pull the trigger. This point was reiterated by San Fransisco Federal Reserve President John Williams Tuesday:
...I still expect inflation to move back up to our target over the next couple of years. With a strengthening economy, special factors dissipating, wages on the rise, inflation expectations stable at 2 percent, and, importantly, full employment right around the corner, I see all the factors in place to meet our inflation goal by the end of next year. But the point of being data dependent is that information drives your decisions; and while my forecast looks great, I am wary of acting before gathering more evidence that inflation’s trajectory is on the desired path...
...policy is data dependent. And the difficulty of being data dependent is that data can be all over the place. Until I have more confidence that inflation will be moving back to 2 percent, I’ll continue to be in wait-and-see mode...
Two other points from the Williams speech worth considering. First is that I suspect the Fed is cautious but not yet terribly worried about events abroad. I doubt Williams is much of an outlier when he says:
...I visited China recently, and I arrived fully cognizant of the concerns people highlight—slower growth, the unsustainability of the current export-driven model, debt buildup, bubbles in the equity and housing markets, the risk of falling investment, and the overall international implications of those risks. But I have to say that, after talking to officials and academics there, I was a lot less concerned about China’s near-term economic outlook on my return flight than I was heading over...
...As for Greece, an ultimate decision appears to be a moveable feast. What I can say is this: Yes, there are risks, but I see them as unlikely to overturn the otherwise strong fundamentals of the U.S. economy...
...While a worst-case scenario of a Greek exit from the euro leading to sizable financial and economic impacts on the global economy cannot be ruled out, it remains an unlikely tail risk...
Second is that Williams has a fairly depressing view of potential growth:
Looking towards next year, what we really want to see is an economy that’s growing at a steady pace of around 2 percent. If jobs and growth kept the same pace as last year, we would seriously overshoot our mark. I want to see continued improvement, but it’s not surprising, and it’s actually desirable, that the pace is slowing.
Mediocre with a capital "M."
Bottom Line: The US economy is plain vanilla. Clearly not accelerating enough to justify a faster pace of monetary policy normalization, but not slow enough for the Fed to abandon their hope of at least initiating the first rate hike this year. They are still looking for stronger numbers, however, to pull that trigger. Fed officials on average are cautiously optimistic the issues in China and Greece will not spill over to the US economy, giving them the opportunity to hike rates. Still, in the absence of confirmation of that hypothesis, those issues still decrease the odds of a rate hike this year. This is especially the case if the recent decline in commodity price places renewed downward pressure on inflation. Such an outcome would raise the bar on the strength of the remaining data to justify a rate hike. In her speech Friday, we will hopefully learn more of Federal Reserve Chair Janet Yellen's view on the importance of Greece and China for US monetary policy.
