Wednesday, March 9, 2016

Fed Has Slack

Fed officials must be very pleased to see that the unemployment rate is under 5.0% and that the core PCED inflation rate is approaching 2.0%. However, the doves among them, especially Fed Chair Janet Yellen, might justify slowing the pace of monetary normalization so that they can be more certain that the economy has normalized for sure. They can argue that there is still slack in the labor market. The recent rapid increase in the labor force suggests that workers are coming back because they’ve heard that there are plenty of job openings and they are finding jobs. The influx of reentering as well as new workers seems to be keeping a lid on wage inflation, which is another sign of slack in the labor market.

With regard to inflation, a few Fed officials recently have signaled that they prefer to target the headline rather than the core inflation rate since the plunge in oil prices seems to be having a depressing impact on inflationary expectations. Using the PCED measure, the former was 1.3% y/y while the latter was 1.7% during January. I wouldn’t be surprised if Fed officials started to suggest that they wouldn’t mind if the core rate overshot their 2.0% target for a while. Now let’s have a close look at all the recent data that members of the FOMC are likely to depend on when they meet on March 15-16--and most likely decide to do nothing and to signal nothing about another rate increase at the next meeting on April 26-27:

(1) Earned income. Friday’s employment report for February was sweet and sour. Payrolls rose solidly (0.2%), but wages edged down (-0.1) and weekly hours worked declined (-0.6). As a result, our Earned Income Proxy, which tracks private-sector aggregate wages and salaries, declined by 0.5% m/m. (See our YRI-EIP.)

(2) Employment. Payroll employment rose 242,000 last month, and the previous two months were revised up to 172,000 during January and 271,000 during December for a total gain of 685,000. Even more impressive is that the household measure of employment jumped by 1.6 million over the past three months, while the labor force surged by 1.5 million. With the significant influx of reentering and new workers in the labor force, the civilian labor force participation rate finally seems to be turning up.

(3) Wages. This is Yellen’s dream scenario. However, it is only starting to play out. The rise in the labor force confirms her view that there is plenty of slack still in the labor market as previously discouraged workers who dropped out come back into the labor force. The slack thesis is also corroborated by the relative weakness in average hourly earnings, which rose only 2.2% y/y last month for all workers. Yellen has previously said that she would like to see wages rising between 3% and 4%.

(4) Trade. Also on Friday, the Commerce Department reported that the US trade deficit widened more than expected in January as a strong dollar and weak global demand helped to push exports to more than a five-and-a-half-year low, suggesting that trade will continue to weigh on economic growth in the first quarter. On an inflation-adjusted basis, exports fell 2.2% m/m and 3.8% y/y to the lowest since February 2014. West Coast ports’ outbound container traffic fell 8.1% y/y through January.

The trade-weighted dollar is down 3.0% from its recent peak on January 20, but remains up 19% since July 1, 2014. That’s clearly weighing on exports. This is yet another reason to postpone further rate hikes so that the dollar doesn’t move still higher.

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