The next FOMC meeting is just two weeks away. Fed hawks had hoped that this was their moment in the sun. I suspect they will need to wait another three months before their next opportunity to act. Signs of a second half rebound are likely too tentative for the doves to tolerate a rate hike. I don't think they will roll over as easily as they did last December.
The August employment report was not terrible. Not by any measure. On the positive side, labor supply is reacting to both demographic changes and stronger demand:
The demographic shift - essentially, the aging of the Millennials toward their prime age working years - is I believe a powerful secular force supporting the economy. That said, the Fed needs to ensure cyclical forces do not undermine the economy. And that is where the story becomes tricky. Is the economy slowing sufficiently on its own that the Fed should refrain from rate hikes? Or is the slowing still insufficient to quell the inflationary pressures Fed hawks in particular believe to be building?
On first take, the slowing in payroll growth is modest:
And arguably sufficient to place additional downward pressure on the unemployment rate. Cleveland Federal Reserve President Loretta Mester recently repeated this view, which is widely held within the FOMC. Via Reuters:
Mester, a voting member on the Fed's policy-setting committee, had earlier in the day told a philanthropy conference that the U.S. economy probably needs to generate between 75,000 and 150,000 jobs per month to keep the jobless rate stable.
Hiring has been stronger than that this year and the U.S. jobless rate is currently at 4.9 percent.
"The economy is basically at full employment," Mester said.
This "full employment" view is also evident in the Fed's estimate of the natural rate of unemployment:
This, not inflation directly, seems to be driving Fed hawks toward a rate hike. See former Federal Reserve President Narayana Kocherlakota here. It is the perceived threat of inflation, not the actual, realized threat of inflation.
Fed hawks will also point toward wage growth as evidence of tighter labor markets that foreshadows inflationary pressures:
Fed doves, however, will not be without their own interpretation of the data. The flattening of the unemployment rate could indicate supply side pessimism on the part of the hawks. That is the positive story that still fits with a no hike scenario. A more negative story is that the flat unemployment rate is consistent with late cycle patterns:
Similarly, progress toward reducing underemployment has stalled noticeably, leaving underemployment at very high levels:
Perhaps the household data is picking up a degree of slowing not yet evident in the establishment data? And on the establishment side, temporary help services payrolls are holding in a late cycle pattern as well:
As far as wages are concerned, Fed doves will say that wage growth is still anemic in comparison with past cycles and - they should add - that wages are a lagging indicator. The Fed should be paying much more attention to forward indicators. And those forward indicators remain tentative at best. The hawks' basic case is not just that the economy is at full employment, but that a second half rebound will send it beyond full employment. And while consumer spending supports the second half rebound story:
the ISM reports draw that into question. Today's service sector report was particularly disconcerting with weakness across the board - the sharp drop in new orders should give FOMC members reason for caution. Doves will thus say the Fed can't count their chickens before they hatch. And this is especially important given that the Fed continues to miss its inflation target, and a misstep at this juncture with overly tight policy will basically guarantee they miss it for the next five years as well.
Indeed, while Fed hawks such as Vice Chair Stanley Fischer and Boston Federal Reserve President Eric Rosengren see progress toward the inflation goals, Peter Olson and David Wessel, writing in the WSJ, conclude:
The inflation rate is higher now than it was in 2015. But over the course of 2016 we’ve seen no apparent progress toward the 2% inflation target. If anything, the inflation rate in January was closer to the Fed’s goal than in July. So it’s increasingly difficult for Fed officials to rely on current inflation numbers as a justification for raising rates. Higher inflation might be just around the corner, but we haven’t seen it yet.
I agree. The "progress" that Fischer and Rosengren point to occurred early in the year, mostly in January. Recent trends have been less promising. The hawks "inflation is here" story is not particularly compelling. Indeed, I would say it borders on disingenuous. Moreover, I suspect the inflation numbers will prompt strong opposition to a rate hike this month. Recall from the recent minutes:
A couple of members preferred also to wait for more evidence that inflation would rise to 2 percent on a sustained basis.
I suspect these two members were Governors Lael Brainard and Daniel Tarrullo. My guess is that neither will roll over on a rate hike as they did last December; I think they probably question the wisdom of the outcome of that meeting. Furthermore, I think they pull Governor Powell and ultimately New York Fed President William Dudley to their side. St. Louis Federal Reserve President James Bullard is ambivalent about when the next 25bp hike occurs; in his framework, the Fed is already within spitting distance of the correct policy stance. He won't push for a hike. And I suspect that Chair Janet Yellen will thus ultimately see too little consensus to support a rate hike.
Bottom Line: Despite being near the consensus view of full employment, incoming data on the second half remains too tentative to support a rate hike this month. This is especially the case given lost momentum in the labor market, particularly with regards to underemployment, and the weak inflation numbers. Hence I do not anticipate a rate hike in September. Why might I be wrong? Aside from just being wrong on the Fed's likely interpretation of the incoming data, perhaps because I have underestimated the Fed's perception that the risks are not really asymmetric - that they have all the tools they need to fight the next recession even if they are at the zero bound - or that the Fed views financial stability concerns as trumping the inflation outlook.
