Federal Reserve policymakers are turning a cautious eye to the inflation numbers, but for now believe special factors account for much of the weakness. Consequently, they remain more focused on the labor market in their policy deliberations. For now, that implies they will resist changing their expectations of further tightening this year as the US jobs market continues to hold strong. Tomorrow we should see more evidence of that strength.
Inflation continues to come in below expectations. The latest PCE inflation report, for example, was better than March but still anemic:
This weakness has not gone unnoticed on Constitution Ave, but Fed officials are not ready to call it quits on the expected path of monetary policy. Federal Reserve Governor Lael Brainard said earlier this week:
Even so, I see some tension between signs that the economy is in the neighborhood of full employment and indications that the tentative progress we had seen on inflation may be slowing. If the tension between the progress on employment and the lack of progress on inflation persists, it may lead me to reassess the expected path of the federal funds rate in the future, although it is premature to make that call today.
Her colleague, Governor Jerome Powell, appears less concerned:
Core inflation was 1.5 percent for the 12 months through April. This measure has also risen since 2015, although its gradual increase appears to have paused because of weak inflation readings for March and April. Some of the recent weakness can be explained by transitory factors. And there are good reasons to expect that inflation will resume its gradual rise.
On the other side of the country, San Francisco Federal Reserve President John Williams repeats the same:
Meanwhile, although inflation has been running somewhat below the Fed's goal of 2 percent, with the economy doing well and some of the factors that have held inflation down waning, I expect we'll reach that goal by next year.
The tendency to dismiss weak inflation numbers will continue as long as unemployment plumbs fresh lows for this cycle. Central bankers believe they are in the range of full employment, and don't want to risk being too far below their estimates of the neutral interest rate when inflation finally does take hold a bit more aggressively.
But will unemployment continue to push lower? The labor market appears to maintain considerable momentum. Initial claims remain low, ADP anticipates private sector job growth for May at 253k, and the ISM employment index picked up. See Calculated Risk for the rundown. Wall Street anticipates job growth of 185k for May within a range of 140k to 231k. My expectation is just on the north side of the consensus number:
This should be enough job growth to maintain downward pressure on unemployment; as the economy matures, the Fed anticipates a requirement of only roughly 100k jobs per month to hold unemployment steady. A number closer to 200k will leave it concerned that sooner or later inflation will eventually emerge and it needs to be ahead of that emergence not behind.
Two more interesting points on this from Powell. First, he thinks that labor force participation is near trend levels:
The labor force participation rate, which had declined sharply after the crisis, has now been roughly stable for 3-1/2 years, which represents an improvement against its estimated downward trend. Participation is now close to estimates of its trend level.
This implies that he anticipates the need to slow job growth sooner than later to avoid excessive undershooting of the unemployment rate. Second, he sees wage growth as just about right after accounting for productivity:
Wage data have gradually moved up, consistent with a tightening labor market. Although average hourly earnings are rising only about 2.5 percent per year, slower than before the crisis, much of that downshift may reflect the slowdown in productivity growth we have experienced. For example, over the past three years, unit labor costs - that is, nominal wages adjusted for increases in productivity - have been generally rising a bit faster than prices.
If productivity growth is 50bps lower than just prior to the recession, then real wages are close to target:
So, assuming the Fed maintains its assumptions regarding productivity growth, we don't need to see much faster wage growth for policymakers to become more convinced the economy is near full employment. Another point to remember when analyzing the labor report.
Bottom Line: The Fed's focus remains on the labor market. Hence, it remains focused on two rate hikes and the balance sheet action still to come this year. One of those rate hikes will come this month. If sustained, weak inflation will eventually push it to rethink the path of policy. But the impact of those changes might fall more on 2018 than on 2017.