The Fed's Employment And Inflation Targets Have Been Met, So What Will It Do This Week?

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Summary

The Fed's preferred measure of inflation was above its 2% target in August.

We are at or very near full employment of around 4.8%.

Nevertheless, qualitative data and exogenous factors will likely cause the Fed to "stand pat" on rates.

New tools permit the Fed to even overshoot its inflation target and still snap the money supply back to bring it within the 2% target.

All eyes will be on the Fed Open Market Committee ("FOMC") when it meets on Tuesday, so let's take a quick look at some of the data they'll be perusing.

Remember, that the Fed has two principal charges: "price stability" (which it defines as 2% inflation) and "full employment", which it currently targets at around 4.8%.

First, August "all items" inflation, the Consumer Price Index ("CPI") released last Friday, moved up 0.2% in August, or 1.1%, for the twelve months then ended.

But the Fed's preferred measure of inflation, Personal Consumption Expenditures ("PCE"), less food and energy (F&E) , was up 3.28% at an annual rate for 2016Q2; or 1.6% (from 109.753 in August, 2015 to 111.366 in July, 2016) for the prior 12 months measured from July. (The official August reconciliation from the CPI figure is not yet available.)

When the Fed raised rates by 25 bps in December, 2015, PCE, less F&E, had printed at 3.5% and 2.8% in the two prior quarters. (It printed at 3.2% in 2015Q4). But chastened by the hike, PCE less F&E printed at just 1.5% in 2016Q1.

Chair Yellen noted in a speech in March that the 1.6% figure will weigh in the determination of the FedFunds rate if it pursues additional growth:

...the level of inflation-adjusted or real interest rates needed to keep the economy near full employment appears to have fallen to a low level in recent years. Although estimates vary both quantitatively and conceptually, the evidence on balance indicates that the economy's "neutral" real rate--that is, the level of the real federal funds rate that would be neither expansionary nor contractionary if the economy was operating near its potential--is likely now close to zero.3 However, the current real federal funds rate is even lower, at roughly minus 1-1/4 percentage point, when measured using the 12-month change in the core price index for personal consumption expenditures (PCE), which excludes food and energy. Thus, the current stance of monetary policy appears to be consistent with actual economic growth modestly outpacing potential growth and further improvements in the labor market.

With a 4.9% unemployment rate, the U.S. economy is essentially at "full employment", at least statistically and under current assumptions.

But as I've note previously here, the statistical definition of "full employment" and holistic full employment, the kind one finds in a robust, growing economy are two different things. Holistic full employment means jobs are being created over a wide array of sectors of the economy (professional and business services, transportation and warehousing, construction, information technology, financial services, manufacturing, mining and logging, etc.) and at various wages.

For the last several years or so, nearly all the new employment has come from low-wage sectors, like retail and hospitality, and government subsidized and dependent sectors, like healthcare, education, and social services. While wages have been mostly increasing, they have been increasing from a very low-wage base, not from the wage base of a robust economy.

The Fed has repeatedly assured observers that its decisions will be data dependent, but that does not equate to "data enslaved". Their judgement will be qualitative just as much as it is quantitative.

While FOMC hawks will certainly make their case that enumerated Fed data points have been met, Fed doves have often cited weaknesses in foreign economies, particularly in China, to bolster their case for continuing low rates.

Going into the September meeting, there are also exogenous and prospective developments beyond the Fed's stated data points that will weigh on the rate decision.

Among important US regional economies, the Hanjin bankruptcy's effect on the West Coast, the growing spread of the Zika virus in Florida's tourist areas, and the prospect that Saturday's multistate terror bombings in the New York metro area, if found to be part of a terror cell, could all slow spending, growth, and hiring in those regions. Likewise, low U.S. demand could adversely affect emerging markets, according to this past weekend's Financial Times.

Finally, I would expect that some FOMC members may take the view that "a little bit of inflation", even if it overshoots the 2% objective, is a good thing.

Years ago, the head of the WWII era Office of Price Administration, Leon Henderson, said, "Having a little inflation is like being a little bit pregnant." But back then, inflation, once loosed, was unrestrainable.

We have moved on. In Henderson's time, the FOMC did not have the tools it has now, especially tools it has had since the 2008 financial crisis. Today, the Fed can set the baseline short-term interest rate by paying interest on excess deposits and by engaging in repo transactions and reverse repos. So even if the Fed overshoots its inflation goals, it can snap the money supply back and raise rates relatively quickly.

I suspect when the minutes are released, most or all these issues will be discussed. I also expect rates will remain the same, notwithstanding the objective data points.

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