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Jobs Hold Sway Over Yellen-Carney as Central Banks Splinter

Fed Chair Janet Yellen
Fed Chair Janet Yellen cited weak wage growth last week in testifying to U.S. lawmakers that “significant slack” remains in the job market and is a reason to maintain monetary stimulus for a “considerable period.” Photographer: Andrew Harrer/Bloomberg

Before the Federal Reserve and fellow central banks go to work raising interest rates, they first need others to go to work.

That’s the signal from policy makers worldwide, as even those whose mandates focus on inflation put the health of labor markets at the heart of their decision making. The approach leaves investors bracing for global monetary policies to diverge after the post-crisis embrace of easy money.

Accelerating job creation -- and the hope this will spur wages -- leaves the U.S. central bank and the Bank of England preparing for higher rates by the end of 2015. At the other end of the spectrum, double-digit unemployment in the euro area and stagnant pay in Japan mean stimulus remains the only option.

“Strength in the labor market is a key factor in the change in thinking about when the first rate hikes may occur,” said Nariman Behravesh, chief economist in Lexington, Massachusetts, for IHS Inc. “There’s a huge differentiation in performance now. The frontrunners are speeding up.”

Investors are starting to tune in to the end of synchronized monetary policy, with economists at Goldman Sachs Group Inc. saying shifts in hiring during the past eight months worked well as a simple predictor of rate expectations.

The forward curves for the U.S. and U.K., which gauge investor expectations for rates, show the most-pronounced steepening as unemployment in both countries has fallen to the lowest levels in more than five years. By contrast, the euro-area’s 11.6 percent jobless rate remains close to a record 12 percent as investors bet its benchmark will stay low until at least 2016.

Increased Differentiation

“What’s striking to us is that the market has increased differentiation in policy and done so fairly consistently with the labor markets and the labor markets alone,” said Dominic Wilson, Goldman Sachs’s chief markets economist in New York.

“The labor market continues to provide the best anchor for where policy is going and how policies differ,” he said, noting that this pattern existed in previous economic cycles.

“The thinking has begun to crystallize,” with mid-2015 as the most likely time for the first rate increase by the Fed and potentially an even earlier move by the Bank of England, said Jerry Webman, chief economist at OppenheimerFunds Inc. in New York, which has about $249 billion in assets under management. “The labor market has been the most important single factor.”

At JPMorgan Chase & Co., economists led by Bruce Kasman told investors last week to prepare for the Fed and BOE to raise their benchmarks to 2.5 percent by the end of 2016, while the BOJ and ECB face pressure to expand their balance sheets further.

Stronger Pound

The pound already is strengthening on expectations of higher interest rates in the U.K., while the dollar will advance to 1.25 per euro by the end of 2014, Webman said. He sees the yield on the 10-year U.S. Treasury note passing 3 percent by year-end, up from 2.46 percent yesterday, according to Bloomberg Bond Trader data.

Even in the stronger economies where unemployment has dropped more rapidly than investors or policy makers anticipated, wages may remain an obstacle to higher rates and leave central banks on hold for now. U.S. average hourly earnings, after adjusting for inflation, were flat or down in the past four months. U.K. pay excluding bonuses rose 0.7 percent in the three months through May, the least since records began in 2001, and wages are falling in real terms.

Fed Chair Janet Yellen cited weak wage growth last week in testifying to U.S. lawmakers that “significant slack” remains in the job market and is a reason to maintain monetary stimulus for a “considerable period.”

Spare Capacity

BOE Governor Mark Carney also has said “there’s additional spare capacity concentrated in the labor market that can be absorbed further before we begin to normalize interest rates.” He has argued that real wages must revive to sustain household-spending growth.

Should the U.S. labor market continue improving more quickly than predicted, higher borrowing costs “likely would occur sooner and be more rapid than currently envisioned,” Yellen said. Carney caught investors off guard last month when he said a lift in U.K. interest rates “could happen sooner than markets currently expect.”

Goldman Sachs analysts were among those who revised their forecasts for the Fed’s first rate increase since 2006 after employment data showed an acceleration. Payroll gains exceeded 200,000 for the fifth consecutive month in June, and unemployment fell to 6.1 percent, close to the level most Fed officials predicted for the end of the year. Goldman Sachs now says the central bank will lift its benchmark rate starting in the third quarter of 2015, rather than early 2016.

Raising Projections

Even before the latest jobs report, Federal Open Market Committee participants raised their projections for the level of the federal funds rate during the next two years, while continuing to predict the first increase will come next year.

In the U.K., unemployment has dropped much faster than the Bank of England anticipated just a year ago, when Carney signaled joblessness probably wouldn’t fall to 7 percent before 2016. Instead it passed that mark in February.

One in three economists surveyed last week by Bloomberg now see the BOE raising its benchmark from a record-low 0.5 percent by December. Half said it will wait for the new year. While average earnings in the U.K. still are growing less than 1 percent a year, surveys point to accelerating wages.

U.K. policy makers decided this month to keep their benchmark at 0.5 percent and noted that they “would have the opportunity to consider in more depth the signal to take from the various indicators on the labor market” before they next meet in August, minutes of their July 9 and 10 meeting showed today.

“It’s all about the labor market,” said Rob Wood, chief U.K. economist at Berenberg Bank who previously worked at the BOE. “It’s the only place the bank sees any slack and so that will be a driver of interest rates.”

Cheap Loans

Higher rates aren’t in the cards in the euro area, where ECB President Mario Draghi cut his benchmark and deposit rates last month to record lows and announced new cheap loans for the region’s banks.

The ECB’s objective -- price stability-- is “also affected by the weakness of demand and by the level of unemployment” among other factors, Draghi said at a July 14 hearing. While the labor market has shown improvement in the past few months, joblessness “remains unacceptably high,” he said. “This could become an existential threat.”

While Germany’s adjusted unemployment rate was unchanged in June at 6.7 percent, the lowest in more than two decades, and wages are rising, other nations in the region are faring worse. The euro-area unemployment rate held at 11.6 percent in May with Spain still above 25 percent.

Distant Horizon

“In the euro zone, you are a long way away from anyone looking at the labor market and thinking this is an economy that can deal with higher rates,” said Marchel Alexandrovich, an economist at Jefferies International Ltd. in London.

Unlike the Fed, the ECB targets inflation alone, seeking to keep it just below 2 percent. Still, Deutsche Bank AG’s chief European economist Gilles Moec calculates there is a link between high unemployment and weak inflation at times of economic pain, meaning “the ECB is right to be hyper-accommodative.”

As for the Bank of Japan, policy makers are counting on wage-driven price gains to help secure the nation’s exit from 15 years of sustained deflation that hamstrung the economy. Much of the bump in consumer prices under Governor Haruhiko Kuroda so far has come from a weaker exchange rate feeding through to higher energy costs.

Base wages, which exclude overtime and bonus payments, were unchanged in May from a year before. Kuroda said in a June 23 speech that demand will pick up and rising inflation expectations will lift wages. For now, the lack of gains means the BOJ will struggle to achieve its target of 2 percent inflation, and “will have to continue easing for several years,” said Junichi Makino, chief economist in Tokyo at SMBC Nikko Securities Inc.

For Carl Tannenbaum, chief economist at Northern Trust Corp. in Chicago, the message is clear for investors: “Labor markets are becoming an increasing and significant focus for monetary authorities around the world.”

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