Just when Federal Reserve Chair Janet Yellen and her colleagues will be approaching a decision to raise interest rates, their two mandates will probably be pulling them in different directions.
By June 2015, the jobless rate will be very close to the 5.2 percent to 5.5 percent that policy makers consider full employment, according to the median forecast of economists surveyed by Bloomberg this month. In contrast, the Fed’s preferred inflation gauge will not have budged from its current 1.4 percent.
In a close call, 27 of 50 economists surveyed by Bloomberg from Nov. 12-14 said unemployment at 5.5 percent or lower would prompt central bankers to tighten policy in mid-2015. The rest said inflation below the Fed’s 2 percent goal would persuade officials to hold off.
“Employment is the dominant consideration in the Fed’s policy-making process,” said Neil Dutta, head of U.S. economics at Renaissance Macro Research LLC in New York, who sees no reason to change his call for a benchmark rate increase in June even as fuel prices have retreated. “I would frankly be skewing toward earlier, than later, rate hikes.”
Economists in Dutta’s camp say central bankers will look past too-low price readings because a falling jobless rate is bound to push up wages, which eventually will mean companies will start charging more. Additionally, the drop in fuel costs that’s keeping inflation under wraps will probably not go much further and is unlikely to extend to the majority of other goods and services.
By the middle of next year, “we will have seen changes in conditions that make a higher inflation forecast still plausible,” said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. “Part of it is that I expect a pickup in wage growth next year.”
Increases in pay mean a forecast for an eventual pickup in prices remains valid, said Crandall. “I’m also guessing that the impulse from the current downturn in commodity prices will have ended, if not turned around, by then.”
A majority, or 53 percent, of economists see energy prices picking up again by mid-2015, according to last week’s survey. Just 10 percent see those prices falling further, with 37 percent projecting little change.
The drop in oil prices is primarily a function of a supply shock due to increased production from the U.S. and Libya rather than diminishing demand, and is therefore less threatening to the inflation outlook, said Dutta.
Wholesale prices unexpectedly increased in October as higher costs for services and food outweighed a slump in energy, figures from the Labor Department showed today. The 0.2 percent advance in the producer-price index followed a 0.1 percent drop the prior month. Consumer prices, due Nov. 20, are forecast to have declined 0.1 percent last month.
There are also tentative signs wage pressures are starting to bubble up, said Dutta.
The widely followed average hourly earnings data from the monthly jobs report show a 2 percent advance in the year ended in October, about where it’s been since 2010. That compares with a 3.1 percent increase in the 12 months through December 2007, as the past recession was starting.
Conversely, the Labor Department’s employment cost index showed wages and salaries for civilian workers climbed 0.8 percent in the third quarter, the most since the second quarter of 2008.
“If folks are expecting the Fed to wait for the average hourly earnings series to get up to 3 percent, I think they’re deluding themselves,” said Dutta. “It’s not the best measure for labor costs.”
What’s more, it takes time for a tightening labor market to lead to a pickup in pay and then inflation, said Stuart Hoffman, chief economist at PNC Financial Services Group Inc. in Pittsburgh, who projects the Fed will start raising rates in July.
A rate increase around that time is in the cards because of “the lag between Fed policy actions and inflation rather than the real economy,” said Hoffman. “If push came to shove, they’d start because the employment report was clearly getting closer to their objective,” he said, particularly if other measures of labor-market slack, including job openings, long-term unemployment and rates of hiring were also improving.
A report last week showed that was starting to happen. Employers hired workers in September at the strongest pace since the last recession began and more people quit their jobs than at any time in more than six years, showing Americans are gaining confidence that the labor market was picking up, according to figures from the Labor Department’s job openings report.
Economists at Goldman Sachs Group Inc. in New York are among those not convinced Fed policy makers will be quick to dismiss a shortfall in their inflation goal in deciding when to increase the benchmark interest rate even as employment gains traction.
“The risks of a later liftoff have risen because the one area where the global market turmoil has shifted the outlook is inflation,” Jan Hatzius, Goldman’s chief economist, wrote in a Nov. 20 research report.
The impact on prices from a reduction in the unemployment rate is less precise and timely than the more direct effect of a drop in commodity prices, said Hatzius, who projects the first rate increase will take place next September. Because Fed officials would find it difficult to pin down the exact root cause of cooling price pressures, “if inflation came in meaningfully lower, the liftoff could easily move into 2016.”
The risks are asymmetric, said Hatzius, because a more significant tightening of the job market and pickup in inflation than now projected would pull the first rate increase forward by at most three months, he said.
The personal consumption expenditure price index, the Fed’s preferred gauge, is projected to increase 1.4 percent in the year through June 2015, according to economists surveyed by Bloomberg this month. That’s down from an October forecast of 1.8 percent.
Smaller price increases do give the central bank room to let economic growth pick up and unemployment drop, Federal Reserve Bank of New York President William C. Dudley said in September.
“Depending on where inflation is, I can certainly imagine a scenario where the unemployment rate dips a little below” what the Fed considers maximum employment, he said in a Sept. 22 interview with Matthew Winkler, editor-in-chief of Bloomberg News. “We really need the economy to run a little hot for at least some period of time” to push inflation back up to the 2 percent objective, he said.
Sharon Stark, fixed income strategist at DA Davidson & Co. in St. Petersburg, Florida, is among those who now project the first Fed rate increase will take place in early 2016, on mounting concern over too-low inflation.
“If they’re starting to see numbers going from 1.5 to 1.3 to 1.2, again that’s a disinflationary scenario and I don’t think they would hike rates,” Stark said. Wage growth in the 3 percent to 3.5 percent range is needed to give consumer spending and the economy enough of a boost to underpin inflation, and that’s not likely to happen until unemployment falls below 5 percent, she said.
Too-low inflation puts the economy at risk of falling into a deflationary spiral where falling prices lead to declines in consumer spending as households wait for costs to fall even more. Companies then keep cutting prices in a bid to spur sales.
Minutes of the Fed’s Oct. 28-29 meeting, in which policy makers ended the third round of assets purchases aimed at keeping interest rates low to spur growth, are scheduled to be released tomorrow.
For some of those maintaining that the first rate increase will occur in the middle of next year even as inflation is slow to accelerate, Fed predictability is the key.
“When you talk about the potential instability that will be created just by everyone waiting and seeing when the economy has to start taking its medicine, I think that volatility and the disruption will probably start weighing heavily in Fed decision-making,” said Doug Handler, chief U.S. economist at IHS Global Insight in Lexington, Massachusetts, who projects the first increase will take place in June.
“Just the pressure to get started, to show we are on the way to normalization, to know that we can actually survive the onset of higher interest rates without an economic apocalypse, that will be very important for business confidence going forward,” said Handler.