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Wednesday, December 14, 2016

Bernstein: In advance of the Fed’s announcement on rates tomorrow… [feedly]

In advance of the Fed's announcement on rates tomorrow…
http://jaredbernsteinblog.com/in-advance-of-the-feds-announcement-on-rates-tomorrow/

The Fed started its December meeting today, one in which they are highly likely to decide it's time for another rate hike. Prediction markets are posting a 95 percent probability that the Fed lifts their benchmark interest rate tomorrow from a target range of 0.25-0.50 basis points (hundredths of a percent) to 0.50-0.75. I'm confident that prediction is correct.

So, whassup with that?

Why now?

Why is the Fed likely to raise in this versus prior meetings? What's changed? A lot, actually.

While the Fed is thankfully somewhat insulated from politics, they have to stay on top of interactions between politics, fiscal policy, markets, and growth. The so-called Trump rally—the DJIA is up almost 9 percent since Nov 8—is built on the notion that a business-friendly president whose cabinet is "stocked" with bankers and billionaires will oversee more upward redistribution of growth, along with financial market deregulation.

[The fact that such policies have, in the past, exacerbated inequality and inflated bubbles is clearly not…um…the focus of markets right now. Sometimes I think the fatal flaw of humans reduces to our unwillingness to give a crap about the future (inequality, recession, melting icecaps) when we can have something today. But I digress…]

Operationally, the Trump rally reflects his plan for a big, regressive tax cut (also infrastructure investment, though see below). Inflation and interest rates have firmed significantly since his election, based on the expectation that he'll inject a serious slug of stimulus into an economy which is already nudging towards full employment.

Also, as the jobless rate has fallen, wage growth has accelerated, from around 2 to 2.5 percent, on average. The price of a barrel of oil is also up 15 percent (almost $8) over the past month.

All of this has bumped up inflationary expectations, if not core (sans oil, food) inflation itself. The figure below shows two series of market-derived inflation expectations, both of which turn up pretty sharply towards the end (before the election, but the daily measures show a spike afterwards). There's the "5-year, 5-year forward inflation expectation rate," which captures expected inflation over a five-year period that begins five years from now. It's just above 2 percent (the Fed's target rate), meaning investors expect inflation to average a little over 2 percent between December of 2021 and December of 2026. The 10-year TIPS breakeven rate reflects similar expectations. (This rate is the difference between the yield on bonds that include an inflation risk premium and those on inflation protected bonds; once you "net out" the latter, what's left over is inflation expectations.)

Source: FRED

The thing is, no one knows what president-elect Trump and the Congress will actually pull off. My guess is that these expectations are directionally correct but overblown. There will be a big tax cut, but perhaps not as big as the markets are pricing in. A serious infrastructure dive may also be a bigger question mark than many investors seem to think (Trump's original idea is limited and not well constructed [sic]).

But it doesn't matter what I think. What matters is what the Fed makes of these expectations. More precisely, it's the extent to which such movements signal to a majority on the FOMC (the group that votes on the rate hike) that anchoring inflationary expectations requires a hike. Based on that standard, I can certainly see where they'd react to the recent upturns with tomorrow's predicted increase

But is a rate hike warranted?

What hasn't changed much is the actual, underlying rate of core, PCE inflation, the Fed's preferred benchmark. As you see in the next figure, excepting a few months in early 2012, it's undershot the Fed's 2 percent target for eight years! Moreover, it's generally agreed that the target is an average, not a ceiling, so having been below it for so long, there's room to run above it for a while.

Source: BEA

In fact, it's essential that we do so. Even grizzled full employment warriors like myself agree we're getting close to that long-awaited condition, though underemployment rates and prime-age employment rates are still too high/low, points on which Chair Yellen has been consistently clear. Moreover, the low jobless rate is finally delivering some long-missing bargaining clout to middle- and lower-wage workers, and the last thing those workers need is to fight against the headwinds of higher interest rates.

But isn't their wage growth bleeding into price growth? Not at all. My colleague Ben Spielberg made the following scatterplots. The first one shows yr/yr inflation (PCE core again) against nominal wage growth for blue collar workers in factories and non-managers in services, about 80 percent of the workforce over the full length of the series, which starts back in the mid-1960s.

Sources: BLS, BEA

While wage and price growth correlate over the life of the full series, over the current expansion (gray dots) the correlation goes the wrong way. But, you say, this has been a uniquely weak expansion with wage growth for these workers coming late in the game. OK, I say back, let's look at the strong 1990s recovery (salmon dots; i.e., Ben tells me they're "salmon"; I'm color blind and even if I weren't, I wouldn't use salmon dots), where full employment eventually drove solid real wage gains across the pay scale. Same thing—the correlation again goes the wrong way.

I should mention, non-incidentally, that we got to full employment in the 1990s because Alan Greenspan ignored those telling him that the unemployment rate was falling too far below what was erroneously believed to be the "natural rate" of 6 percent.

OK, perhaps I've convinced you on the wage-growth-not-driving-inflation part of the story (there's academic evidence for this too). But just because you don't see wage pass-through to prices doesn't mean that full-resource utilization, as proxied by low unemployment, won't drive up inflation. Then why hasn't the inflation line accelerated in the PCE figure above? Yes, the scatterplot below shows low inflation at high unemployment, but it also shows low inflation at low unemployment.

Sources: BEA, BLS

Look, the Fed's almost sure to raise tomorrow, and frankly, at this point, I think the volatility induced by surprising markets would be an own-goal kick that the Fed should probably avoid. But I don't trust these recent blip-ups in markets and expectations based on the notion that Trump and his merry band of billionaires are going to be great for investors. And even if they are, a) the Fed may push back the other way by raising rates more quickly, and b) unless unemployment stays very low, none of these goodies are trickling down to workers.

I don't mean to slight the incoming econ team; they deserve a chance and they're certainly inheriting a different economy than the one faced by the team I was on 8 years ago.

But my priors suggest that the Fed may be the only rational, fact-based economists at the controls for a while…maybe a good, long while. They need to block out the noise, remain in data-driven mode, and allow the recovery to continue reaching those who've only recently begun to benefit from it.


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