Last Friday’s jobs report stood at 252K jobs created for the month of December, closing out a year in which both GDP and employment have improved markedly. The economy produced an average of 246K jobs per month in 2013, while GDP grew at 4.6% in the second quarter and 5% in the third quarter. This has suggested to some, such as Cleveland Fed President Loretta Mester, that GDP may be accelerating (as she noted on Fox Business recently at the American Economic Association meetings in Boston); and unemployment, now at 5.6%, is essentially equal to her estimate of the natural rate. This has led her to suggest that rates could move up in the first half of 2015.
To be sure, for every number in the jobs report, it is always possible to find an area that needs improvement and to be concerned about. The participation rate continues to fall, as did the size of the labor force. Average hourly wages declined 0.2% in December, and November’s gain was revised down by half to 0.2%. For the year, wage gains were only up1.6%, as compared to 2% for 2013. The wage data were important to Chicago Fed President Evans, who said in an interview that it was a sign that inflation pressures are still quiescent. To him, this provides room for the FOMC to be patient about raising rates until labor markets improve further, since inflation is still below the FOMC’s target of 2%. Given that inflation is low and the economy is growing and creating jobs, it is unusual for an economist to wish for more inflation. In any case, President Evans indicated in an interview on Friday on CNBC that he could see the Committee waiting until 2016 to begin normalizing rates.
Interestingly, although these two policy makers assessed the current flow of incoming data as essentially positive in a number of important dimensions, one viewed the data as possibly supporting an early move towards rate normalization while the other saw the data as consistent with deferring normalization for a considerable period of time. Other FOMC participants are equally likely to assess these same data differently as well.
Reasonable people can disagree, especially when it comes to assessing the appropriate policy path for an economy exiting from a period about which there is essentially little relevant historical experience to inform decisions. In assessing what the FOMC is likely to do, it is also necessary to point out that while all participants play an equal role when it comes to the dialogue around the table, it is particularly important to keep track of who votes and who does not. In this case, President Mester is a nonvoting participant this year, while President Evans gets a vote.
As for the other voting members, there are presently five sitting governors and one new nominee. We simply have no reading on the nominee’s views. In addition to the Board, the other voting members in 2015 are President Dudley, who has consistently supported the low-interest-rate policy; President Lockhart, who has been with the consensus and never dissented; President Lacker, who has been an outspoken advocate for an early return to normalcy and who has dissented on many occasions when a voting member; and President Williams, who recently saw June of 2015 as a time to “consider when to start raising interest rates.” We must keep in mind that President Williams succeeded Janet Yellen as president of the San Francisco Fed, and his views have tended to align with hers.
What has clearly emerged, despite the widely disparate views among FOMC participants on the appropriate path for policy to return to normalcy, is the constant drumbeat from all the FOMC participants that any change in policy will depend upon incoming data. But since there has as yet been no articulated consensus as to what data will be focused on or how those data might affect a policy decision, we are left with the conclusion that the Committee cannot credibly publicly forecast and disclose what it will do and when it will do it and simply wants flexibility and the discretion to act.
Our view is that the Committee will indeed be both cautious and very patient, for several reasons. First, there is a dovish majority, centered on President Dudley and Chair Yellen, and supported by President Evans and President Rosengren. This group is clearly more inclined to wait before acting, and in the past has been primarily concerned about labor market developments. Vice Chairman Fisher is likely the most hawkish among the current Board members, but has been so far has voted with the majority. Nevertheless, despite the unexpected and substantial improvement in labor markets, we expect the FOMC to turn its attention increasingly to inflation and hold off on acting until inflation actually begins to pick up significantly.
Second, given the low current rate of inflation, there are also reasons to believe that inflation will remain below the FOMC’s 2% target for most of the year. The drop in oil prices, while actually a decline in a relative price, has clearly put downward pressure on measured inflation and will also help keep prices low in those sectors whose profit margins will accelerate simply because of the decline in a significant input cost. Additionally, there are abundant sources of downward price pressure internationally. Europe is still struggling, Russia is in recession, and China has slowed, as has Latin America. Geopolitical uncertainty looms large, and perceptions of risk have certainly not been lessened by this past week’s terrorist attacks in Paris. These factors imply a flight to quality, downward pressure on bond rates, and an appreciation of the dollar, all of which will also help keep prices down.
A third factor putting downward pressure on interest rates is the US budget deficit situation. The US deficit, according to CBO estimates, declined from $1.4 trillion in 2009 to $506 billion in fiscal year 2014 and is projected to be even a bit lower in 2015. The decline in the rate of increase in outstanding Treasury debt, combined with an accelerated demand for collateral and safe assets, has bid up bond prices and lowered rates. Thus, it does seem that labor market conditions, while important, will take a back seat to the FOMC’s inflation objectives as far as Fed policy is concerned. Low inflation suggests that the FOMC can get a free ride for the near term, while waiting out the downside risks due to geopolitical uncertainties and economic slowdowns in the rest of the world which received considerable attention according to the minutes of the December FOMC meeting. For these reasons – and as we have argued over the past year –we don’t see the likely flow of incoming data triggering a rate change at least until September of this year or even later. This is especially the case since FOMC policy in 2015 will continue to be dominated by members who are regarded as being extremely cautious when it comes to changing rates preemptively.