Macroeconomic and Job Market Data Indicate Impending Interest Rate Hike in December
Although the Federal Reserve failed to move in November, markets received a clear indication of enthusiasm to raise rates in the near future (the very near future). Currently, three main indicators predict a Federal Reserve Interest Rate Hike in December: the Feds own statements; macroeconomic growth data; and, jobs and inflation data.
In leaving its interest rate policy unchanged in November, the Federal Open Markets Committee insisted that “the case for an increase in the federal funds rate has continued to strengthen”:
… the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent. The Committee judges that the case for an increase in the federal funds rate has continued to strengthen but decided, for the time being, to wait for some further evidence of continued progress toward its objectives. The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation. …
Real GDP grew at an annualized rate of 2.9 percent during the third quarter, a significant improvement over the average growth of 1.1 percent during the first half of the year. Even though consumption growth has eased from its earlier rapid pace, strong net exports and a turnaround in inventory accumulation have boosted real GDP growth.
As some of the recent strength in net exports should prove transitory and investment and manufacturing performance remains sluggish, real GDP growth should soften somewhat in the fourth quarter. However, annualized growth in the second half of the year should exceed 2.0 percent based on solid consumption growth in the near-to-medium term underpinned by strong fundamentals, such as continued strength in the labor market.
Furthermore, the U.S. economy has continued to progress this year toward the Federal Reserve’s dual-mandate objectives of maximum employment and price stability. Job gains averaged 180,000 per month from January through October, a somewhat slower pace than that of the comparable period for last year but still well above estimates of the pace necessary to absorb new entrants to the labor force. The unemployment rate, which stood at 4.9 percent in October, has held relatively steady since the beginning of the year.
The Labor Market
Labor force growth depends on growth in the working age population as well as the labor market participation rate, which measures the fraction of the working aged who are working or seeking work. The growth rate in the population has slowed over the post-war period and in recent decades the labor force participation rate has declined substantially.
The recent decline in the labor force participation rate partly reflects cyclical factors associated with the recent recession. However, the effect of an aging population provides the principal driver of the trend decline. Since participation is relatively high among the young and prime-aged and substantially lower among older groups, the overall participation rate declines as the older groups represent a larger share of the population. This process will continue in coming years as more baby boomers reach retirement age.
The growth of the labor force determines how many jobs the economy needs to create to maintain full employment. Intuitively,
the more people available or who want to work, the more jobs the economy must provide to absorb them. Calculations of trend labor force growth allow an estimate of the pace of employment growth consistent with a healthy labor market at full employment. In the 1990s, this number appears to have been 150,000 job gains per month. However, due to demographic changes, the “new normal” or “trend” employment growth is now estimated to be approximately 80,000.
Therefore, even if employment growth declines substantially from its current pace to less than 100,000 per month, such a decline would remain consistent with a healthy labor market in which unemployment remains close to its natural rate.
Overall, the labor market has shown gains across the board and overall several key metrics. The latest employment reports present a strong picture for prime-age workers (ages 25-54). Their employment-to-population (EPOP) ratio rose 0.2 percentage points to 78.2 percent, the highest rate since the recovery began. This improvement in prime-age EPOPs occurred for both men and women.
Most promising, the average hourly wage over the last three months increased at a 2.9 percent annual rate compared with its average over the prior three months. Over the last year, the average hourly wage has increased 2.8 percent. More rapid wage growth indicates that workers are leaving low-paying jobs for better paying jobs.
Inflation remains below the Fed’s 2.0 percent target, although it has gradually started rising. Headline inflation, captured by the 12-month percent change in the personal consumption expenditures (PCE) price index hovered at 1.2 percent in September, the highest reading reported since late 2014, partly reflecting a rebound in energy prices. Core inflation, which removes the direct influence of the volatile energy and food price components of inflation, remained at 1.7 percent in September, the same rate reported for August. As the labor market tightens further and the lingering effects of past dollar appreciation and oil price declines subside, core and headline inflation should rise gradually towards 2 percent.
Putting It All Together
The Federal Reserve’s long-run real GDP growth estimate—the rate of potential GDP growth—is 1.8 percent. According to Federal Reserve Vice Chair Stan Fischer last week:
If labor force participation was to remain flat, job gains in the range of 125,000 to 175,000 would likely be needed to prevent unemployment from creeping up. However, if labor force participation was to decline, as might be expected given demographic trends, the neutral rate of payroll gains would be lower. If we assumed a downward trend in participation of about 0.3 percentage point per year, in line with estimates of the likely drag from demographics, job gains in the range of 65,000 to 115,000 would likely be sufficient to maintain full employment.
So, let’s assume labor force growth of 0.3 percent. Together, these two points imply a productivity estimate of 1.5 percent. The Fed’s inflation target is 2.0 percent. The 2.0 percent inflation target plus 1.5 percent productivity growth suggests that the Fed anticipates wage growth of 3.5 percent when the economy settles into full employment. In fact, the 3-month moving average for average wage growth ticked up to 3.3 percent last month:
Although 12-month wage growth still lags at 2.8%, the trend is clearly heading higher. Under these conditions, it is reasonable to believe that the economy has neared full employment. Even underemployment trends, a hotly contested and heretofore obstinate measure of the job market, have declined substantially.
Given the current pace of job growth, the Fed anticipates that the economy is positioned to soon reach or even exceed their mandates.
The Fed faces a familiar dilemma in December (and that meeting is coming up soon). The fed must choose whether to act preemptively, or hold still waiting for labor force and productivity growth to rise futher? Most likely the Fed will take the opportunity in December to act preemptively.
What About the Donald?
Does the election throw a wrench in the Fed’s plans? The prospect of a Republican dominated government buoyed financial markets, sending stocks higher and bonds lower. Some might argue that the bond sell off will induce the Fed to take a pass in December, on the theory that higher interest rates imply tighter financial conditions? Probably not. The steepening of the yield curve likely reflects the prospect of a reflationary policy mix.
Note that the Fed has already accepted and foreseen the prospect of fiscal stimulus as well. As Federal Reserve Vice Chair Stan Fischer noted, via Reuters:
On more expansionary fiscal policy, I think many members of the open market committee and of the Federal Reserve Board have commented it would be useful to have a more expansionary fiscal policy.
The Fed believes that a more expansionary fiscal policy would provide them greater room to “normalize” interest rates. Hence they will be closely watching the evolving fiscal agenda. Although it remains premature for the Fed to update its economic projections dramatically, regarding the December rate decision, the prospect of substantial fiscal stimulus must count as an upside risk for growth and inflation. Note also that market-based inflation expectations tell the same story:
Given that the economy has almost already reached the Fed’s estimates for full employment, the risk of fiscal stimulus should imply a risk of a higher rate path in 2017 and beyond. Assuming no change in productivity or labor force growth, the Fed would likely consider a full monetary offset to any fiscal stimulus in order to avoid substantially higher inflation.
With the economy hovering near full employment, the Fed will seek to press forward with a December rate hike. Furthermore, as the Trump administration takes over, the Fed will feel compelled to offset fiscal stimulus in order to preserve their inflation target. This is particularly the case for any large
stimulus (Republican administrations have historically been pro-deficit spending and have enlarged the national debt).