By Philip Lachowycz
Strong growth has meant the unemployment rate is falling rapidly. Although we may not be there yet, it is clear that the NAIRU is fast approaching. The FOMC statement for July removed language referring to the unemployment rate remaining 'elevated' while acknowledging that the risk of inflation running persistently below target had diminished. Indeed one member, Charles Plosser, dissented because he was unhappy with the assertion that rates would remain on hold for an extended period after asset purchases had come to an end.
The market seems convinced that the Bank of England will raise rates before the Fed. We are less certain. The US economy is better placed to deal with higher rates and therefore we would not be surprised if the Fed moved before the Bank of England.
US fundamentals are strong
Ever since the global economy bottomed out some five years ago, we have been optimistic about the US recovery. The US was one of the first major economies to recover its pre-crisis level of output - this landmark was passed as long ago as 2011 Q2. Nevertheless, the Great Recession was unlike any other post-war recession. That is well understood. The initial drop in US output was much larger, and the pace of recovery a little slower, than in the past. That is why the level of US output is still some way short of what would normally be seen at this stage in the recovery.
Although the US may face an important headwind, in the form of a structural decline in participation associated with an ageing population, we see little evidence that the financial crisis has had a sustained impact on labour productivity - perhaps the most important determinant of a country's standard of living. In comparison to other major economies, it is the performance of productivity that makes the US stand out. The impact of the financial crisis is barely visible in US productivity data. By contrast, UK productivity fell some 5% through 2008 as the crisis hit. It has subsequently stagnated. Both the euro area and Japan have fared better than the UK, but their performance has been a long way behind that of the US.
Labour market tightening rapidly
US job creation continues apace. In May, the level of employment surpassed its previous peak, and in the twelve-months to June the US economy created 2.495 million jobs. That is the largest yearly increase in payrolls employment since 2006.
Robust job creation combined with falling participation, means that the unemployment rate has fallen dramatically. The unemployment rate now stands at 6.1%. Clearly, that is some way below the FOMC's 6.5% threshold, which until March had been a marker for the point at which it was appropriate to contemplate a change in interest rates. The Great Recession was clearly different and more severe than other recessions and the unemployment rate unsurprisingly rose by far more than in previous downturns. However, the unemployment rate no longer looks out of the ordinary.
Closing in on the NAIRU
Our next chart presents a range of estimates of the non-accelerating inflation rate of unemployment, or NAIRU. According to the OECD, US unemployment is already at the NAIRU. It is closing in rapidly on the CBO's estimate of the short-term NAIRU, although it remains some 0.6 percentage points above the top of the central tendency range of FOMC members' forecasts of the longer-run unemployment rate. If unemployment continues to fall at the pace that has been seen on average over the past year, it would hit the CBO's estimate of the short-run NAIRU in September of this year, and the median of FOMC members' forecasts of the longer-run unemployment rate in December.
The Beveridge curve measures the ease with which unemployed workers are able to match with the available jobs. The closer the curve is to the origin, the more efficiently the labour market is working and the lower will be the NAIRU. Since 2007, there has been a clear rightward shift in the Beveridge curve - the extent of mismatch in the labour market has increased. The bursting of the US housing market bubble, which was more prevalent in some parts of the country than in others, may have been a crucial factor. US states that saw a bigger house price boom also witnessed far larger increases in unemployment - with the loss of jobs in construction particularly severe. In addition, households in those states were much more likely to be faced with negative equity on their houses after the bubble had burst. That is likely to restrict their movement, meaning that they cannot move to where the vacancies are, reducing the efficiency of the labour market.
The NAIRU is a difficult concept to measure, especially in real time. The precise number is less important than the fact that the US is clearly approaching it - and fast. And it is doing so with a negative real rate of interest. Our next chart plots the difference between the unemployment rate and the CBO's estimate of the NAIRU on one axis and the inverse of the real policy rate on the other. It illustrates how unusual the current situation is. Generally, as the labour market approaches equilibrium, policy is tightened. However, this time policy has remained on hold and that is with an unprecedented amount of monetary stimulus.
Is the tighter labour market feeding through to wages?
To date, US wage growth has been tepid, but positive in real terms because pay gains have been supported by productivity growth. That said, wages have been weak and only just above CPI inflation. However, the latest employment cost index showed a rise of 0.7% in the second quarter - the strongest quarterly increase since 2008. And, looking ahead, a survey from the National Federation of Independent Business, which has some leading indicator properties, shows that the net proportion of small firms planning to raise wages is up sharply over the past few months.
Core inflation has picked up in the past few months with the increase in the inflation rate spread across components. The pick-up in core inflation has surprised us. Back in January, we were forecasting that core CPI inflation would remain steady at around 1.7% through 2014. It did not reach 2.0% within our forecast horizon. Most of the upside surprise has been driven by costs related to housing, but market inflation expectations have risen too. The rise in inflation may be a little bit more than "noise" as Fed Chair Yellen has described it.
Joining the dots
The FOMC's latest minutes made no reference to the point at which Committee members expected to raise the Fed Funds rate. Particular weight is given to comments made by the Fed Chair, presumably because Janet Yellen's predecessors, Ben Bernanke and Alan Greenspan, were never on the losing side of an FOMC vote on monetary policy throughout their tenures. Following her unfortunate 'six months' comment back in March, the FOMC Chair has been particularly careful to avoid providing calendar guidance. Until recently, Ms Yellen's rhetoric has remained firmly on the dovish side, exerting a downward pull on market participants' expectations across the curve. The gap between the 'dots' - which represent the median forecast among Committee members for future levels of the Fed Funds rate - and the market curve is unusually large at present. Our own view is that the dots are presently much closer to the likely path of the Fed Funds rate than the market curve.
Chair Yellen's words before the Senate Banking Committee left the door ajar to earlier-than-planned rate hikes 'if the labor market continues to improve more quickly than anticipated.' If our estimate of a figure in the region of 310K for July payrolls is correct, the 'north pole of inflation hawks', James Bullard, who has predicted a rate rise by the end of Q1 2015, may well be proved right.
In our view, judging whether it is the Fed or the BoE that will move first is less easy than current pricing might suggest. Looking at the chart below, it would appear that markets consider a UK interest rate hike is more likely than not by December of this year. That same threshold is not crossed in the case of the US for a further six months. We have written at length about the damage inflicted on the supply side of the UK economy by the ongoing banking crisis. Although productivity continues to expand at close to its pre-crisis rate in the US, unemployment is falling rapidly in both economies.
Where the economies differ markedly is in the ability of each to absorb an interest rate increase. A key measure of the vulnerability of households to a change in interest rates is the proportion that have taken out variable rate mortgages, known as ARMs in the US. In the US, the proportion of homeowners taking out ARMs has fallen dramatically since the financial crisis hit. That is because falling bond yields have allowed households to take advantage of cheap fixed-rate mortgages, and encouraged homeowners to refinance. However, UK households remain sensitive to interest rate changes as over 70% of outstanding mortgages are on a variable rate. The vulnerability of the UK household sector to changes in interest rates means the MPC will seek to keep rate rises to a minimum.
Substantial cuts in policy rates of interest, almost to zero, were necessary to prevent what we now call the Great Recession from becoming another Great Depression. However, as the BIS made clear in its Annual Report last month, the policy has not been costless. Raising rates from the lower bound is not always an easy task. So far, the BoJ and the ECB have both tried and failed. But the Fed has less to worry about than other central banks. The US banking system is functioning well, particularly in comparison to its peers; adjustment in the US housing market is complete, with the house-price-to-income ratio now below its historic average; and, in view of the structure of the US mortgage market, the impact of a relatively modest tightening on debt servicing costs in the US is likely to be small. With the labour market tightening rapidly, and inflation surprising on the upside, there is a real chance that the Fed may be the first to move.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: Alpha Now at Thomson Reuters is a team of expert analysts that are constantly looking at the financial landscape in order to keep you up to date on the latest movements. This article was written by Philip Lachowycz, independent commentator and analyst. We did not receive compensation for this article, and we have no business relationship with any company whose stock is mentioned in this article.