The US Federal Reserve’s campaign to lift interest rates (I.e. ’normalise’ monetary policy) will continue the week after next when the central bank is expected to lift its key indicator by 0.25%.
Some economists reckon there could be another increase later in the year. But at the moment the economic conventional wisdom backing the rate hikes is being turned on its head.
In fact there are growing doubts that the Fed’s reasons for lifting rates will not last past this month’s 4th increase of its current cycle.
The Fed has been lifting rates because unemployment has been falling and the fear was (up to the end of 2016) that wages were starting to break out and rise quickly. The fear was that wage growth had to be corrected to stop inflation breaking higher as well.
But that hasn’t happened and inflation and wage growth has fallen in the first five months of 2017, as unemployment has dropped to a 16 year low of 4.3% in May from %% in late 2016.
In fact the US economy, the labour market and inflation are not doing what the Fed thought they would be doing when rates first rose at the end of 2015.
US GDP is rising sluggishly – an annual rate 0f 1.2% in the March quarter against 2.1% in the December quarter and 3.7% in the three months to September. The slowdown in growth since September has been noticeable and not confined to the first quarter, as the Fed seems to be telling us in various commentaries.
Retailing is weak, care sales are now falling, business investment has been buoyed by the new drilling in shale oil areas, production is solid and exports though are mixed.
But there is no single factor (such as jobs) to point to to say this tells us the need for further rate rises has passed. But a couple more months of weak jobs growth will be enough to call an end to the Fed rate hikes – even though the central bank regards the slowdown as “transitory”.
But could the three rate hikes have clipped growth and expectations to the point where they are starting to impact growth?
The Fed has a dual mandate – maximising employment and stabilising prices and this translates to keeping inflation around 2% and maintaining a buoyant labor market.
The latter has now been fact for the past four years, but the former has yet to happen for more than four and a half years.
Its a trade-off, as more and more jobs are created and the unemployment rate falls, there is supposed to be a trade off – some time wages will start rising faster than wanted in response to the tighter labour market and in turn boost inflation.
(It’s usually analysed through what is called The Phillips Curve – a supposed inverse relationship between the level of unemployment and the rate of inflation-the lower the jobless rate the higher the inflation rate).
The Fed’s longterm jobless rate is 4.7% (so the May rate is now well below that) where the trade off between inflation and wages is supposed to see inflation accelerating. The jobless rate has fallen from 4.8% to 4.3% so far this year, with nary a blip in inflation – the real story is that it has fallen.
As Federal Board governor Lael Brainard pointed out on Tuesday, that inflation measured by the core PCE gauge has undershot the Fed’s target for 58 straight months, even as the unemployment rate has halved. The most recent numbers, released on Tuesday, showed core inflation of just 1.5% — below the Fed’s 2% target.
Including Friday’s May jobs and other data, America has created more than 16 million new jobs since 2010 and pushed the unemployment rate down to a 16-year low of 4.3% in May. In fact . Since January, the unemployment rate has declined by 0.5 percentage point, and the number of unemployed has decreased by 774,000. But wages growth have fallen, along with inflation.
In fact the strongest labor market in years still hasn’t translated into significantly higher wages for Americans workers and there is absolutely no sign of inflationary pressures anywhere in the American economy as a result.
The May jobs report on Friday night said hourly pay rose at a 2.5% rate in the 12-month period ending in May, unchanged from the prior month and down from a post recession peak of 2.9% at the end of 2016. Wage growth was not surprised to slow once the jobless rate fell under 5% – it picked up briefly towards the end of 2016, but has now reversed.
But the slide in the jobless rate was expected to boost wage growth to 3% and beyond as it fell under 5% – in past recoveries in the US wages have typically grow an annual 3% to 4% rate when the economy is strong and the unemployment rate is as low as it is now at 4.3%.
There are a host of reasons advanced for this – from insecure workers, to a lack of skills, to the rapid growth in low paying unskilled jobs (in companies such as Amazon), low productivity, global competition, aggressive employers, rising health care costs – the attempted explanation are many and probably right collectively.
As well some companies are increasing automation in some areas to offset a rise in US minimum wages, but that hasn’t impacted employment.
But the fact is that the fall in the unemployment rate and the tightening jobs market has failed to ignite inflation (just as the huge quantitative easing spending of the Fed and other central baks haven’t triggered a surge in inflation as a chorus of henny pennies claimed they would.
After peaking at 1.9% at the end of 2016, inflation as measured by the Fed’s favoured indicator – to so called Personal Consumption expenditure index (or PCE) fell to 1.5% in May. Weak oil prices have helped trim inflation, but that is not the answer.
There is now a small chance that the Fed’s rate rises may backfire as wages growth and inflation fail to follow theory and accelerate.
Despite all the Fed arguments and justifying there is currently no inflationary threat from the tight jobs market and hasn’t been for the past 58 months.
