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Weekly Commentary by Dr. Scott Brown

A slowdown in job growth
June 6 – 17, 2016

“The data in today's labor market report on balance suggest that the labor market has slowed. Nonfarm payroll employment increased at an average monthly pace of 116,000 over the last three months--well below the 220,000 per month average pace over the preceding twelve months. The unemployment rate moved lower, reaching 4.7%, a new low in the current recovery, but involuntary part-time employment increased and the labor force participation rate declined. Even so, there are reasons to expect that the labor supply still has room to respond if labor demand increases.”

– Fed Governor Lael Brainard, June 3, 2016

The economy added nearly 697,000 private-sector jobs in May. That’s before seasonal adjustment (in comparison, we added 996,000 in May 2015). One month does not necessarily make a trend, but figures from March and April were revised lower, reinforcing the view that (seasonally adjusted) job growth has slowed. The question, for the Fed and for investors, is why.

Mild winter weather may have pulled forward seasonal job gains into the spring. Prior to seasonal adjustment, the economy added 2.91 million jobs from January to May, vs. 3.19 million over the same period last year. That’s not a huge difference.

There is a fair amount of statistical noise in the payroll data. Figures are reported accurate to ±115,000. We can be 90% certain that the true monthly change in payrolls was between
-77,000 and +153,000. We can reduce the impact of statistical noise by looking at the three-month average: private-sector payrolls at +107,000, vs. a +214,000 average over the 12 previous months. So yes, job growth appears to have slowed significantly.

In its sampling, the Bureau of Labor Statistics misses new firms and firms going out of business. The birth/death model corrects for this. The birth/death model correction (to unadjusted payrolls) was +224,000 in May, vs. +217,000 a year ago. The birth/death model does well under normal conditions, but misses turning points. If wrong, the May figure would be even worse.

Surveys have shown an elevated level of business caution. Worries about global growth, the June 23 Brexit vote, possible Fed policy actions, and the presidential election have led firms to delay capital spending projects (even though they have the means to finance expansions). There are signs that some firms pared inventories in anticipation of weaker demand, only to struggle a bit to restock as demand ended up stronger than expected. Until recently, there weren’t many signs that firms had curtailed hiring (if the economy were to slow more significantly, you can always lay off workers, but if you make capital expenditures, you may be stuck with idle plant and equipment).

Job growth was strong in the last two years, but the pace was naturally expected to slow this year as the job market tightened. Anecdotally, many firms report difficulty in finding qualified workers. Perhaps more precisely, firms are having trouble hiring workers for the wages that they are willing to pay. There’s still a strong emphasis on cost containment. The job market has tightened, but average hourly earnings are still up only 2.5% y/y.

The unemployment rate fell to 4.7% in May, the lowest since before the recession. However, that’s still a bit misleading, as labor force participation is well below the pre-recession level. The employment/population ratio for the key age cohort (those between 24 and 55) has been trending higher, but the level still suggests that there is plenty of slack in the job market. Perceptions of labor market slack have been the key factor in competing policy views at the Fed. The more hawkish Fed district bank presidents often get more press than they deserve.

One opinion matters more than others, that of Fed Chair Yellen. Yellen will speak on the economy and monetary policy in different contexts over the next three weeks. Financial market participants might want to pay attention. The Fed remains in tightening mode, looking to resume the normalization of monetary policy. However, given the recent data, officials should be in no particular hurry to raise rates.

Fed communication
May 30 – June 3, 2016

“If I turn out to be particularly clear, you've probably misunderstood what I've said.”– Alan Greenspan

In recent decades, the Federal Reserve has become much more open. However, Fed communications have not always been received clearly by financial market participants. That has become problematic on a number of levels.

We’ve come a long way from the days when monetary policymaking was an obscure process and the central bank was viewed as a mysterious priesthood. Prior to 1994, the Fed did not even announce changes to the federal funds target rate. The Fed now issues a policy statement describing the economic outlook and the reasoning behind policy decisions. Detailed minutes are released three weeks after policy meetings. The Fed chair now conducts press conferences four times per year, explaining in some detail how decisions are reached and taking question from the press. And yet, market participants are often confused by the Fed, unsure of what the central bank is doing.

Former Fed chair Alan Greenspan was famous for obfuscation. By blowing verbal clouds of smoke, he often appeared to be intentionally vague, and that stance generally worked for the financial markets. Communications with the public began to get clearer during Greenspan’s tenure. Ben Bernanke, his successor, made communications a top priority. Where Greenspan was vague, Bernanke was crystal clear. However, Bernanke found that the message was not always getting across. Bernanke would often say something like “a, but possibly b” and market participants would hear the “a” part or the “b” part, but not put the pieces together. This was especially troublesome when the Fed exhausted conventional monetary policy (lowering rates close to zero). Unconventional policy (forward guidance, large-scale asset purchases) should not have been all that controversial, but to paraphrase Mark Twain, “a tweet by Sarah Palin can circle the globe in the time that Ben Bernanke is putting on his shoes.” The Fed Chair did a great job in explaining why the Fed was doing what it was doing and what the risks were, but that effort was often overshadowed by certain politicians forecasting hyperinflation and a worthless dollar. This matters a lot, as the Fed faces the prospects of “reform” from Congress.

“In determining the timing and size of future adjustments to the target range for the federal funds rate, the [FOMC] will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.”
– April 27 FOMC statement

More open communications have also be an important goal during Janet Yellen’s tenure as Fed chair and she too has had some difficulty in getting the message across. Currently, the Fed’s main directive is that policy decisions will be data-dependent, centered on improvement in labor market conditions and the inflation outlook. However, it’s still going to be a judgement call. Fed policymakers will consider a wide range of economic information, including anecdotal information. Yet, data are bound to be mixed. How will the Fed weigh mixed economic signals? Officials will have their own views, and the Fed will have to balance those views as it tries to achieve a consensus policy stance. Certain Fed district banks (we’re looking at you, Philadelphia and Richmond) have been historically hawkish (inclined to raise rates early and more often). The Fed governors tend to be more pragmatic. The Fed’s Governors (five currently, with two nominees lingering in the Senate) dominate the voting district bank presidents and Chair Yellen dominates the governors. However, it’s not a dictatorship. Yellen, much like Ben Bernanke, is open to hearing other points of view and decisions are reached by consensus.

It’s certainly no secret that the Fed wants to normalize monetary policy. Exceptionally low levels of the overnight lending rate are not the norm. The question is how rapidly the Fed wants to get there. The policy risks are asymmetric. It will be much easier to correct course if the Fed finds that it raised rates too slowly (it merely would have to raise rates more rapidly). However, there are limited options if the Fed discovers that it has raised rates too quickly.

The Fed is currently replacing mortgage prepayments and maturing Treasuries by purchasing new securities. The end of this reinvestment policy was expected to be the first step in policy normalization under Bernanke, but the order has shifted under Yellen. In March, Yellen said this policy will continue “until normalization of the level of the federal funds rate is well under way.” Maintaining the reinvestment policy should provide some insurance against a possible future adverse shock to the economy. When the reinvestment policy ends, the size of the balance sheet should decline naturally over time.

On the other hand…
May 23 – May 27, 2016

“Give me a one-handed economist!”

– Harry S. Truman

The minutes of the April 26-27 Federal Open Market Committee meeting has returned monetary policy to the list of financial market worries. However, while most Fed officials believe that a June rate hike could be in the cards, that doesn’t mean that rates will be raised next month. On the one hand, there are reasons to resume policy normalization. On the other hand, there are reasons to delay. The end results will depend on how the Fed balances the data and the risks.

“Participants agreed that their ongoing assessments of the data and other incoming information, as well as the implications for the outlook, would determine the timing and pace of future adjustments to the stance of monetary policy. Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee's 2 percent objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June. Participants expressed a range of views about the likelihood that incoming information would make it appropriate to adjust the stance of policy at the time of the next meeting.

– FOMC Minutes (April 26-27)

As with recent monetary policy meetings, the June 14-15 FOMC meeting will be a “live” meeting. That means that Fed officials will discuss a possible increase in the federal funds target rate. However, the decision will depend on the economic data between now and then. A majority of Fed officials believe that if economic growth shows signs of picking up, the labor market continues to improve, and inflation appears likely to head higher, then it will be appropriate for the Fed to raise rates. However, officials differ in their expectations of whether that criteria will be met. It’s still a judgement call. The FOMC minutes showed that “several participants were concerned that the incoming information might not provide sufficiently clear signals” that a rate increase would be warranted. On the other hand, “some participants expressed more confidence that incoming data would prove broadly consistent with economic conditions that would make an increase in the target range in June appropriate.” Some officials thought that financial market participants had not properly assessed the likelihood of a June rate hike and stressed the importance of communicating clearly how the Fed would respond to economic and financial developments.

The risks of a policy error remain significant and one-sided. The upside potential for growth appears limited, but the Fed could easily tighten policy more rapidly if needed. While there are moderate downside risks to growth, there are limited policy options to address a weakening in the economic outlook. This is why the Fed has adopted a cautious stance on raising rates.

Market participants have consistently foreseen a much shallower glide path for short-term rates than Fed policymakers have expected. At the same time, the dots in the dot plot (Fed officials’ expectations of the appropriate level of the federal funds rate for the next few years) have drifted lower quarter after quarter (the next update of the dot plot is set for June 15). In other words, the Fed has gradually moved closer to market expectations rather than the other way around. Yet, the markets may be lured into a false sense of complacency, perhaps believing that rates can’t be raised because doing so would unsettle financial conditions. The Fed can try to have it both ways, by talking tough, but at some point it would have to follow through with an actual rate increase to insure credibility.

The Fed needs to normalize monetary policy over time, no doubt, but the arguments for tightening sooner rather than later are not especially compelling, while the arguments for delaying policy action are. One line of reasoning for delay is especially persuasive. It’s very difficult for the Fed to raise rates when business fixed investment (capital spending) is contracting.

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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