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Weekly Commentary by Dr. Scott Brown

High anxiety
December 15 – December 19

Federal Reserve policymakers meet this week to set monetary policy. The key concern is the timing of policy normalization. Officials may be anxious to begin lifting short-term interest rates, but they need to be very careful about managing market expectations. The risks of tightening too soon or too late are not symmetric and with the financial markets in turmoil, the Fed will not want to add to the level of anxiety.

The liftoff for short-term interest rates will be driven largely by the Fed’s view of the labor market. There are many labor market gauges. The Labor Market Conditions Index, a composite of 24 indicators, provides a good summary (according to Fed Chair Yellen). While there is some choppiness from month to month, the underlying trend suggests that labor market slack is being gradually taken up and momentum in the job market has been strong in recent month. Still, a lot of slack remains and it will likely be two years or more before we get to what might be considered “normal” labor market conditions.

Working back from where the job market is expected to be in two years and assuming a slow pace of rate hikes (25 bps per FOMC meeting), then it would seem appropriate to begin tightening around the middle of next year. The Fed would not be hitting the brakes. Rather, it would simply be gradually taking the foot off the gas pedal.

What are the risks of tightening too soon or two late? If the Fed tightens too soon and the economy slows, it will have a limited ability to correct course, as short-term interest rates are already close to zero and officials will be very reluctant to pursue another round of quantitative easing. If the Fed tightens too late, the economy would begin to overheat and inflation would begin to rise. However, the Fed has the scope to raise short-term interest rates more rapidly – that is, it has a greater ability to correct its course.

In 2011, inflation picked up. Some observers feared that the Fed was behind the curve and wanted it to unwind accommodation. Instead, the Fed cited “temporary factors” and focused on core inflation, and continued to act aggressively. The current low inflation trend is also seen, by many Fed officials, as transitory. Low inflation, by itself, is not enough to postpone a Fed tightening. However, the conditions driving low inflation matter. For example, some of the drop in energy prices reflects increased supply. The Fed need not worry about that. However, some of the drop reflects weaker demand, which is a concern. Yet, the drop in demand is coming from the rest of the world. It’s not due to weakness in the domestic economy.

What about the stronger dollar? Would the Fed postpone tightening to reduce the upward pressure on the greenback? Remember, the exchange rate of the dollar is not the Fed’s responsibility. The dollar is under the Treasury’s jurisdiction (although the Fed may intervene in the currency markets on behalf of the Treasury). Yet, the Fed needs to consider the impact of a stronger dollar. A stronger dollar, as we’ve seen, puts downward pressure on commodity prices, but the impact at the consumer level is usually small. It takes a major move in prices of raw materials to move consumer prices even a little. The exception is oil, where the decline has a bigger impact and shows up relatively quickly. Still, oil prices are not expected to fall forever. They should stabilize at some point.

Following NY Fed President Dudley’s recent speech, we now know that the Fed will also consider the financial market reactions (or overreactions) to its policy moves, and possibly react to the market’s reaction. The recent stock market turmoil and drop in long-term interest rates makes the Fed’s decision to remove the “considerable time” phrase a lot more complex. Janet Yellen can attempt to calm the financial markets in her press conference, but will the markets listen?


The fed, jobs, and the financial markets
December 8 – December 12

Looking ahead to 2015, the labor market is expected to play the key part in the Fed’s path to policy normalization. However, as we learned from New York Fed President Dudley last week, the Fed will also consider the reaction in financial markets.

Recall that the employment report is comprised of two separate surveys. The Establishment Survey, which covers about 144,000 businesses and about 554,000 individual worksites, yields data on nonfarm payrolls, hours, and earnings. The Household Survey, which samples about 60,000 households, provides data on the unemployment rate and labor force participation (as a rule, the Household Survey does not generate good estimates of levels, such as the size of the labor force or the number of unemployed, but you do get reasonable estimates of ratios, such as the unemployment rate).

Job growth has been relatively strong this year. In fact, in the first 11 months, nonfarm payrolls have risen more than in any year since 1999. Nonfarm payrolls were reported to have risen by 321,000 in November, the largest monthly gain in nearly three years. However, one should take this large gain with a grain of salt. There is a fair amount of noise from month to month and the data are subject to revision. Still, the underlying trend in payrolls is encouraging. Average hourly earnings rose 0.4%, but that too is subject to revision and followed a modest 0.1% rise in October – up 2.1% from a year ago, still well below what might be considered a “normal” pace (3.5% to 4%).

The Household Survey data were less impressive in November. The unemployment rate was unchanged at 5.8%. The employment/population was flat (at 59.2%), up only gradually over the last year (58.6% in November 2013). The e/p ratio for the key age cohort, those aged 25-54, was up moderately over the last year (76.9%, vs. 76.0%), suggesting that labor market slack is being taken up only gradually.

The percentage of people working involuntarily part time and the long-term unemployment rate have both been improving, but they remain relatively high by historical standards.

Monetary policy is expected to be driven by Fed officials’ interpretations of the job market data in the months ahead. How much slack remains in the job market? How rapidly is that slack being taken up? How much wage pressure are we likely to see, and will firms be able to pass higher labor costs along? These are going to be hard question to answer. As we saw in the November Employment Report, the data often send conflicting messages. Monetary policymakers will have to weigh the evidence, but also use that evidence to make projections.

Last week, New York Fed President William Dudley presented his 2015 economic outlook and the implications for monetary policy. What stood out were his comments on the Fed’s reaction to the financial markets’ reaction to monetary policy. The Fed not only has to react to what the data mean for the economic outlook. It also has to react to changing financial conditions. Consider the unhelpful taper tantrum in 2013, when the Fed didn’t really do anything, vs. this year’s drop in bond yields as the Fed gradually reduced its monthly asset purchases. The markets could overreact to Fed policy signals or move in the wrong direction. It’s enough to make your head spin. The October FOMC minutes show that officials were fearful that financial market participants could misinterpret a decision to abandon the “considerable time” phrase. What might the markets do when the Fed signals that a rate hike is imminent?

Ultimately, investors should not fear the Fed. The first hike in short-term interest rates should be viewed as a natural consequence of the improvement seen in the overall economy. There is some danger that the markets might overreact, but the Fed is likely to take that overreaction into account as it considers possible further action – 2015 is going to be fun!


Monetary policy outlook
November 24 – December 5

The minutes of the October 28-29 Federal Open Market Committee meeting suggested that there is still no consensus opinion among senior officials regarding when the Fed will begin raising short-term interest rates. There is strong agreement that monetary policy moves will be data-dependent. However, policymakers differ in their views on the amount of slack in the job market. Only “a few” Fed officials expressed concerns that inflation might persist below the Fed 2% target. However, while survey-based measures of long-term inflation expectations had remained stable, “market-based measures of inflation compensation had declined somewhat.” While this bears watching in the U.S., it’s a much bigger worry for the euro area.

“Indicators of labor market conditions continued to improve over the intermeeting period, with a further reduction in the unemployment rate, declines in longer-duration unemployment, strong growth in payroll employment, and a low level of initial claims for unemployment insurance. Business contacts reported employment gains in several parts of the country, with relatively few pointing to emerging wage pressures, although one participant indicated that larger wage gains had been accruing to some individuals who switched jobs. Labor market conditions indexes constructed from a broad set of indicators suggested that the underutilization of labor had continued to diminish, although a number of participants noted that underutilization of labor market resources remained. A couple of participants judged that the large number of individuals working part time for economic reasons and the continued drift down in the labor force participation rate suggested that the unemployment rate was understating the degree of labor market underutilization.”
– FOMC Minutes (October 28-29)

The labor market slack debate has grown in recent weeks. One issue is how to weigh the various measures. The Kansas City Fed’s Labor Market Conditions Index provides a handy summary. The LMCI suggests that slack is being taken up, perhaps a bit more rapidly in recent months. However, it also indicates that a lot of slack remains. Other parts of the debate focus on which measures of slack matter more. Currently short-term unemployment (those out of work for six months or less) is trending low (at a level which we would normally associate with a job market that is running at full steam). Longer-term unemployment (more than 6 months) has been trending lower, but remains relatively high by historical standards. Some economists have argued that long-term unemployment is largely irrelevant to the inflation outlook. Last week, New York Fed economists argued that it does matter. There are enough people on the sidelines (not officially counted as “unemployed,” but who would still take a decent job if one were offered) to keep wage pressures relatively muted.

The major surprise in the October 29 policy statement was the absence of concern about low inflation. In policy statements in the first half of this year, the FOMC noted that “inflation persistently below the 2% objective could pose risks to economic performance.” This sentiment was missing from the October policy statement, but also from the FOMC minutes. Many economists had expected that the current low trend in inflation and downward inflationary pressure coming from the rest of the world would lead to a delay in the first Fed rate hike.

Inflation Compensation, the spread between fixed rate and inflation-adjusted Treasury securities, is not an exact measure of inflation expectations. However, recent values suggest a lower inflation outlook over the next five years and over the five years after that (the five-year rate five years forward).

As inflation expectations fall, real interest rates rise, which has a negative impact on growth. Nominal interest rates can’t be lowered. This isn’t a big concern for the U.S. economy just yet, but it is a critical problem for the euro area, where the economy is much weaker than in the U.S.


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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