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Weekly Commentary by Dr. Scott Brown

Jobs, inflation, and wage pressures
July 20 – July 31

In her monetary policy testimony to Congress, Fed Chair Janet Yellen made it clear that the central bank remains on track to begin raising short-term interest rates later this year. However, she gave herself an out, indicating that Federal Reserve officials’ projections of the federal funds rate are “based on the anticipated path of the economy, not statements of intent to raise rates at any particular time.” Moreover, she continued to imply that people should stop worrying about the timing of the initial move and focus on the projected path over the next couple of years, which she expects to be gradual. None of this has helped ease the market’s anxieties about the Fed’s timing.

The unemployment rate hit 5.3% in June, but that overstates the improvement in the job market. Fed Chair Yellen has highlighted a number of gauges, including hiring and quit rates. The number of people working involuntarily part-time has been falling, but is still higher than normal. Yellen: “while labor market conditions have improved substantially, they are, in the FOMC's judgment, not yet consistent with maximum employment.”

The inflation outlook is an important factor in the Fed’s decision to begin raising rates. For some time, policymakers have indicated that they need to be “reasonably confident” that inflation will move toward the Fed’s 2% goal. Inflation was pushed lower in the first half of the year due to lower oil prices and a stronger dollar. After falling sharply into the early part of the year, the dollar has been essentially range-bound since mid-March – but that could change. In the short term, exchange rates largely reflect central bank policies. The Fed is considering when to tighten. The ECB has undertaken quantitative easing and Mario Draghi, the central bank’s president, has signaled no intention of curtailing asset purchase plans (which are set to continue to September 2016). The Bank of Canada lowered rates last week for the second time this year. The Fed anticipates that the decline in oil prices will run its course, relieving downward pressure on consumer price inflation in the months ahead. However, crude oil prices have turned down again and longer-term futures contracts (which, granted, aren’t a great predictor of spot prices) point to a sustained period of low oil prices. Low inflation may last longer than the Fed expects.

The federal funds futures reflect a lower rate trajectory than what the Fed was projecting in June. However, the futures reflect some chance that the Fed will have to reverse course and lower rates after the initial increase. That risk is not included in the Fed’s projections. Still, financial markets seem to carry some doubt about the Fed’s willingness to begin raising rates.

Looking ahead, the financial markets are expected to remain sensitive to economic reports, especially those concerning the job market and inflation. On July 31, the Bureau of Labor Statistics will release the Employment Cost Index for 2Q15. The first quarter figure suggested that labor compensation might be picking up, reflecting budding inflation pressures and reduced labor market slack. The 2Q15 figure should suggest otherwise.


The view from the fed
July 13 – July 17

Federal Reserve Chair Janet Yellen will give her semiannual monetary policy testimony to Congress this week. In the past, this has been an important event for the financial markets. However, Fed communication is a lot more open these days. For example, we have the forecasts of senior Fed officials and the minutes of the June policy meeting in hand. However, there is still scope for financial market participants to learn a bit more.

Over the last several months, Fed officials have made it clear that monetary policy decisions will depend critically on job market conditions and the inflation outlook. Job growth has remained strong. The unemployment rate has continued to decline and is now near levels that were once considered to be consistent with “full employment.” However, that figure presents a false image due to shifts in labor force participation. Some of that is demographics, the aging of the population. The Kansas City Fed’s Labor Market Conditions Index indicates that slack is being taken up, but considerable slack remains.

There are many measures of “core” inflation. One can exclude food and energy. It’s not that these don’t matter. Rather, monthly changes in food and energy are often volatile and we are interested in the underlying trend. Trimmed measures exclude the highest and lowest price changes. The Atlanta Fed’s sticky price index looks at prices of goods and services that change only gradually. Of these measures, the one the Fed focuses on (the PCE Price Index ex-f&e) is trending at the lowest level (that doesn’t mean that the Fed is wrong).

More importantly, the Fed isn’t worried about past inflation; the focus is on future inflation. The drop in energy prices and the strong dollar have put downward pressure on inflation over the last year, but as they stabilize, their impact on inflation will fade. In domestic production, there are no signs of the type of bottleneck pressures that would push prices higher. The labor market is the widest channel for inflation pressure. There are some signs that wage growth has picked up, but the pace has remained relatively lackluster. Average hourly earnings were reported to be flat in June, up just 2.0% from year ago.

Still, the Fed has to base policy on where the economy is expected to be many months down the road. Simply eyeballing the LMCI graph, it looks as if the labor market is on track to achieve some sense of normality in late 2016. The Fed is not going to wait until we get there to begin policy normalization. The best analogy is that while there is no pressing need for the Fed to hit the brakes, it does need to begin taking the foot off the accelerator in the not too distant future.

Yellen ended her July 10 speech on the economy by bringing up the issue of productivity growth, the most important factor in the long-term economic outlook. However, it’s unclear why output per worker has slowed in recent years. A long-lasting low trend in productivity would have important implications for the standard of living, but also for wage growth (slower), interest rates (lower), and the federal budget deficit (wider).


More of the same
July 6 – July 10

The U.S. economic data reports have remained mixed, consistent with a moderately strong pace of growth in the near term. The June jobs data suggest that a September Fed rate hike may be a closer call than thought earlier. Meanwhile, Greece’s economy is in tatters. The country has to face the burden of further austerity or the chaos of a euro exit.

Payrolls rose by 223,000 in June, not far from the median forecast (+230,000), but figures for April and May were revised a net 60,000 lower. At 221,000, the average monthly gain in 2Q15 was still strong, by historical standards.

The unemployment rate dipped to 5.3% in June, the lowest since April 2008. However, the decline was due to a further drop in labor force participation, the lowest since 1977. That’s likely just noise (statistic uncertainty and seasonal adjustment issues), but the employment/population ratio suggests that a considerable amount of slack remains in the labor market. Slack is being taken up, but (despite strong job growth over the last year) we are still a long way from a full recovery in employment.

The job market outlook will be a key factor in the Fed’s decision to begin raising short-term interest rates. Policymakers have also signaled that they need to be “reasonably confident” that inflation will move toward the 2% goal (core inflation, as measured by the PCE Price Index, rose 1.2% for the 12 months ending in May). Wage growth is the key issue in both of these policy triggers. Reduced labor market slack should eventually lead to wage pressures and, barring a rise in productivity growth, higher labor costs are likely to be eventually passed along to consumers. Last month, average hourly earnings were reported to have risen by 0.3% in May, generating some fear the rising wage pressures would force the Fed to begin tightening sooner rather than later. In contrast, the June jobs report showed earnings unchanged in June, while the May increase was revised down to +0.2%. That left nominal earnings up 2.0% for a year ago, the same lackluster pace of the last few years. 

The Fed need not wait for “the white of inflation’s eyes” before raising rates. Monetary policy is based on where officials expect the economy to be in a year. Chair Yellen has noted that policy will still be “very accommodative” even after the first couple of hikes. On the other hand, the risks aren’t symmetric. Tightening too soon would be more costly than moving too late. However, the more important question is the pace of tightening beyond the initial hike. That pace is expected to be gradual, but it could be made even more measured if the economy were to stumble or grow more slowly than anticipated.

Greece votes on July 5 whether to accept further austerity conditions, but it’s unclear what will happen regardless of the outcome. “Yes” would mean a new government, new negotiations, and further uncertainty. “No” would likely lead to an exit from the monetary union, but that’s not entirely clear. Greece’s economy is going to suffer either way and global financial markets are likely to remain stressed in the near term.


The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.

All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.

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