There is growing concern on Wall Street that there may be less slack in the job market than the Federal Reserve perceives, leading to a scenario where the central bank finds itself “behind the curve” with regard to winding down unprecedented levels of extraordinary monetary stimulus as inflation returns.
Aneta Markowska, chief U.S. economist at Société Générale, writes in a note to clients that “Could the Fed hike rates in 2014?” is one of the top questions that has come up in recent meetings with investors.
The Fed has kept the federal funds rate, its main policy tool, pinned in a range between 0 and 0.25% for five years in a bid to max out monetary accommodation, and it said in its latest policy statement on December 18 “that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 per cent, especially if projected inflation continues to run below the Committee’s 2 per cent longer-run goal.”
According to the Fed’s own projections, that means the first rate hike likely won’t come until the end of 2015.
The monthly release of official employment figures from the U.S. Bureau of Labour Statistics on January 10, however, revealed that the unemployment rate plummeted from 7.0% to 6.7% in December.
The proximity of the current unemployment rate to the Fed’s threshold is stoking the debate on Wall Street surrounding a potential scenario that has largely been lost in all of the negative sentiment toward the pace of economic recovery in recent years: what if the central bank’s own projections for prices and the labour market are too pessimistic, and justifications for continued stimulus are quickly waning?
“Albeit 20 years ago, 1994 has not yet left the collective memory of markets, and the fear is that 2014 could see a replay hereof,” says Markowska.
Key to the debate is to what extent recent declines in labour force participation — one of the drivers of downward pressure on the unemployment rate — are cyclical (i.e., reflecting economic weakness) versus structural (i.e., resulting from longer-term trends like demographics).
If the decline in participation is largely cyclical, inflation is not a threat. If it is structural, then there will be a smaller pool of workers available to fill job openings as the economy picks up, and the risk becomes upward pressure on wages and inflation.
Fed officials fear a significant amount of the decline in participation is cyclical, which is why they have increasingly sought in recent communications to downplay the 6.5% unemployment rate threshold for consideration of rate hikes in order to push out the market’s timeline for when the central bank is expected to move.
“We see part of the decline in the participation rate as structural, part as cyclical,” says Markowska. “Should the bulk (contrary to our baseline scenario) prove structural, this would imply significantly less spare capacity in the U.S. labour market and could force the Fed to move early to stem inflation risks.”
A breakdown of BLS employment data by Ellyn Terry, an economic policy analysis specialist in the research department of the Atlanta Fed, provides support for the structural argument. It shows that the majority of those who have exited the labour force over the past four years were over 60 years of age.
“The substantial growth (both absolute and relative) of older workers coupled with a decline in the participation rate for this age group suggest that recent participation rate declines may not prove temporary,” says Drew Matus, deputy chief U.S. economist at UBS.
“Although we believe that there could be a modest cyclical rise in participation as the economy improves, we believe the likely scale of the increase will not significantly alter the basic equation: payroll growth averaging 200,000 per month should continue to pull down the unemployment rate under all but the most aggressive labour force expansion estimates.”
Still, almost no one predicts rate hikes are imminent.
A rare exception is Bank of Tokyo-Mitsubishi chief financial economist Chris Rupkey, whose prediction that the Fed will begin hiking rates in late 2014 lies squarely outside the Wall Street consensus.
“I am waiting for them to wake up and smell the coffee,” said Rupkey of Fed officials in December.
“They keep talking down the economy, where there is greater strength out there than they think. I do not see the underemployment they see.”
Despite gains in the labour market, inflation remains elusive. The year-over-year change in the price index of core personal consumption expenditures (the measure of inflation the Fed cites in its policy statements) was only 1.1% in November, well below the central bank’s 2% target.
“Inflation is the new unemployment,” writes Credit Suisse chief economist Neal Soss in a note to clients.
“Should upcoming data prompt a rise in inflation expectations, the Fed’s commitment to low rates will start looking less credible,” warns Soss.
If that happens, he says, “look for the markets to test the Fed’s forward guidance, perhaps repeatedly, over the course of the year.”