The Final Countdown

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Includes: RINF
by: Tim Duy

The latest read on the Fed's preferred inflation metric was not particularly kind to policymakers:

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Indeed, as Craig Torres at Bloomberg notes, this is only one of a number of indicators that should give a reality check to FOMC participants as December's meeting approaches. A stronger dollar, weaker commodity prices, and falling inflation expectations suggest that the "transitory" negative weights on inflation might persist longer than the Fed anticipates.

In addition, since I last wrote, real-time estimates of fourth-quarter GDP weakened in the face of incoming data. And manufacturing data is off to a weak start this month with a fall in the Chicago PMI. Indeed, manufacturing indicators are weaker than we would normally see at the onset of a tightening cycle, but the Fed is betting that these indicators are passé in a world dominated by services. And that side of the economy seems to be holding up nicely:

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We get fresh national readings from the Institute of Supply Management this week. Still, even if the numbers are on the soft side, there is little I think that will dissuade officials from hiking rates in December. With unemployment at 5% and wage growth picking up to confirm receding slack in the labor market, the general consensus on Constitution Avenue is that the time is ripe to nudge rates higher. Wait any longer, the thinking goes, and you risk being unable to raise rates "gradually." It will be interesting to see how the Fed would react to a weak November labor report, due Friday. It seems as long as the employment report is not a complete disaster, even numbers on the soft side would be enough to justify Fed action on the basis that the underlying trends remain in place.

As Torres also notes, even if December is pretty much in the bag despite questions about inflation, the path of subsequent rate hikes will depend on confidence in the path of inflation. Boston Federal Reserve President Eric Rosengren via an extensive interview with FT:

My own personal view is we should have a flexible approach to thinking about the path with gradual being the important consideration, but we are still not near 2 per cent inflation. By the core PCE at 1.3 per cent we are still pretty far away. What gives me reasonable confidence about the path of inflation is the fact that the labour market slack seems to be diminishing relatively quickly. But I would want to continue to see progress on wages and prices moving up. If we weren't seeing wages and prices moving up over time our willingness to keep raising rates would go down... 

So it is partly conditional on whether that reasonable confidence, as your rates get higher you should probably want a standard that is a little higher than reasonable confidence. I would not expect to continue to see 1.3s for the core PCE. If we continue to see 1.3 [per cent] for the core PCE we would have to think about why is inflation not picking up towards our 2 per cent goal.

Will wages and prices move higher? I would be surprised if this wasn't the case, assuming, of course, the economy maintains sufficient cyclical momentum to sustain further improvements in the labor force. An often-overlooked point is that wage growth is arguably not as puzzling as it seems. Consider the Atlanta Fed Wage Growth Tracker, which estimates median wage growth of matched individuals, those with earnings now and twelve months ago. By tracking persons with continuous employment over a year, this metric avoids the problem of compositional effects due, for example, to persons entering the labor force, and those leaving the labor force due, for example, to demographic shifts or cyclical factors. The Atlanta Fed measure compared to other measures of wages:

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The Atlanta Fed measure accelerated in 2015 as unemployment moved below 6%:

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Note the deceleration in wages in recent months; this is attributable to lower wage growth for women. Looking at men only, the relationship between unemployment and wage growth is somewhat tighter:

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The Atlanta Wage Growth Tracker suggests that the underlying relationship between unemployment and wages remains intact. Weaker-than-expected wage growth seen in traditional metrics is thus attributable to compositional effects. These effects should lessen as unusually high levels of underemployment continue to recede (although demographic change will continue as high wage workers retire), and thus, traditional wage metrics should accelerate. That is the Fed's expectation as well.

But what about inflation? Will inflation necessarily move higher as the labor markets improve further? That is still an open question. Rising wages would be evidence of decreasing economic slack, and Federal Reserve Chair Janet Yellen has said she anticipates inflation to rise back to target as slack diminishes and the transitory impacts on inflation wane. Indeed, if the economy reverts to an equilibrium similar to that seen in the late 2000s, we would expect both wage growth and inflation to both move roughly 100bp higher as unemployment declines toward 4.5%. In such a scenario, real wage growth would be unchanged. Indeed, adjusting the Atlanta Fed numbers for inflation indicates that real wage growth has already returned to the late 2000s range of 1.5-2% year over year:

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It appears that the economy transitioned to lower real wage growth relative to the late 1990s in response to the productivity slowdown.

Hence, I think the base case of rising wages and prices remains reasonable - assuming sufficient cyclical momentum to carry unemployment lower still. But how much tightening can the economy weather before that cyclical momentum wanes? Therein lies the Fed's challenge. Employment indicators tend to be lagging, and the economy may already be already easing into a soft patch. Conor Sen sees that the drivers of growth this cycle are abating, and hence, activity will need to be a transition to new drivers. Note also signs that the US credit cycle is already tightening, and the rising levels of distressed debt (only a third of which is oil & gas-related). In other words, if the economy is indeed at an inflection point, with credit conditions already tighter, the room for tightening is likely limited - and the room for error is higher. This is likely more so the case in a world of low interest rates; in such a world, policy might turn tighter more quickly than in previous cycles.

Bottom Line

Just how data-dependent is the Fed when it comes to December? Not much, I think. They are likely just looking for evidence that basic labor market trends remain intact to justify pulling the pin on higher rates. Absent any sharp financial disruptions or disastrous data, it looks like we are on the final countdown to the first rate hike of this cycle. Beyond that, they will proceed very cautiously; this is especially the case if they don't see evidence of still-declining slack in the form of rising wages and inflation. And if the economy turns choppy as the drivers of recent growth lose their momentum, policy will turn choppy as well. Indeed, in such an environment, future rate hikes would likely come in fits and starts. Thus, while 100bp of tightening is a reasonable baseline for next year, the path is not likely to be a smooth 25bp every other meeting. That will likely pose some interesting communication challenges for the Fed.