This week’s meeting of the Federal Open Market Committee is really about September.
Fed officials aren’t ready to raise rates on Wednesday, and they know it going into the meeting. It’s a foregone conclusion. September’s meeting, however, is not. Thus, this week’s meeting is really about gauging the likelihood of a September liftoff. And that likelihood will depend in large part on the Fed’s confidence in hitting its inflation target—which Fed officials may feel is much closer than many people think.
Do other monetary policymakers believe sufficient progress has been made to put September in focus?
Turn to the Fed’s thinking on the first rate hike as described in the minutes of the June FOMC meeting:
In considering the Committee’s criteria for beginning policy normalization, all members but one indicated that they would need to see more evidence that economic growth was sufficiently strong and labor market conditions had firmed enough to return inflation to the Committee’s longer-run objective over the medium term.
Break that up into three parts—growth, labor, and inflation. On the first point, incoming data suggest activity held firm in the weeks following the June FOMC meeting. The Federal Reserve Bank of Atlanta’s GDPNow measure has been modestly gaining ground:
Note this range remains broadly consistent with the central tendency estimates of potential growth from the Fed’s Summary of Economic Projections. In other words, actual growth rebounded to—or perhaps even a bit above—potential growth. Policymakers will take comfort in these numbers as they confirm their suspicion that first-quarter weakness was largely much ado about nothing. In addition, authorities in Europe dialed back the tail-end risk from the Greek crisis, eliminating at least momentarily one impediment to hiking rates. China, however, still remains a wild card. On net, concerns over the growth outlook eased somewhat since the June meeting, increasing the Fed’s willingness to consider September.
Similarly, labor market data show steady underlying trends despite a first-quarter swoon, with job growth rebounding:
Meanwhile, measures of labor underutilization generally continued their slow yet steady improvement in June. Underlying growth, it seems, remains sufficiently strong to drive further improvement in the labor market.
But is the combination of the growth and employment outlook sufficient for FOMC members to be confident that inflation will return to target? If these numbers hold or improve for another six weeks, the answer will probably be yes by the time the September meeting rolls around.
Consider first that with both oil prices and the dollar stabilizing since the beginning of the year, the transitory impact on inflation fades:
Second, the Fed will point to other measures of inflation as evidence that its preferred measure, PCE inflation, will trend toward target over time. Notably, core CPI is tracking higher than core PCE:
Also, core PCE closed in on target on a three-month basis, providing substantial reason for policymakers to believe the deceleration of the latter part of 2015 has largely played itself out:
And note that Fed officials may believe they’re really not that far, if at all, from target in the first place.
The Federal Reserve Bank of San Francisco recently concluded:
Taking into account the volatility of monthly inflation rates, the recent departure of 12-month inflation from the 2% target rate does not appear particularly significant or permanent in comparison with earlier episodes. Moreover, since the early 1990s, the empirical Phillips curve relationship that links inflation to the deviations of production or employment from their longer-term trends appears roughly stable. Hence, continued improvements in production and employment relative to their long-run trends would be expected to put upward pressure on inflation.
Below target inflation? Where? Move along, folks, nothing to see here. Yet even if the inflation picture firms while the labor market continues to improve, it’s worth asking: Is that same labor market sufficiently tight to justify a rate hike? Policymakers need a reasonable level of confidence that full employment lurks around the bend. We’re getting closer, to be sure, but stubbornly persistent weak wage growth belies the conjecture that little slack remains.
Still, evidence mounts that the wage growth story is turning, a point highlighted by none other than Federal Reserve Chair Janet Yellen:
Finally, the pace of wage increases also may help shed some light on the degree of labor market slack, since wage movements historically have tended to respond to the degree of tightness in the labor market. Here too, however, the signal is not entirely clear, as other factors such as longer-run trends in productivity growth also generally influence the growth of compensation. Key measures of hourly labor compensation rose at an annual rate of only around 2 percent through most of the recovery. More recently, however, some tentative hints of a pickup in the pace of wage gains may indicate that the objective of full employment is coming closer into view.
More anecdotal evidence of an inflection point comes from the July Beige Book:
Wage pressures were modest across most areas of the country, outside of some specialized skill and high-demand occupations in sectors such as information technology, transportation, and construction. Reports from Kansas City and San Francisco were more robust, indicating intensifying wage pressure across a broader range of industries. Cleveland, Chicago, and San Francisco all highlighted a growing sense among business contacts that recent announcements of minimum wage hikes and pay increases at a number of large retailers could prompt broader wage pressure across other industries as firms compete to remain attractive employers.
Overall, I sense there is a growing confidence among policymakers that wage growth will soon accelerate. That confidence is likely sufficient enough to move the Fed closer to the first rate hike. Still, hard data is better than anecdotes. Solid evidence of accelerating wage growth in the next two labor reports would go a long way toward convincing FOMC members that they could safely move in September.
Would Yellen acquiesce to a September rate hike?
While she is viewed as supporting only a single hike in 2015, there’s no reason to believe that hike must come in December. Yellen has made two points abundantly clear with respect to policy normalization: She prefers “early and gradual” over “late and steep,” and she anticipates policy will not be on a preset path as it was in the last tightening cycle. As pointed out by Greg Ip, these preferences justify a September rate hike on a risk management basis. The risk of policy shifting to “late and steep” only increases as the economy approaches full employment. The Fed can address that risk by moving in September. But a hike in September does not guarantee a hike in December; the Fed could take a pass at that meeting. Hence, Yellen could move in September and, if justified by the data, deliver only one 25-basis-point rate hike in 2015, while at the same time throwing the Fed hawks a bone.
Bottom Line: At this week’s meeting, policymakers will be judging the distance to the first rate hike. I think they will make their way through an analysis similar to above and conclude that distance has certainly closed since the last FOMC meeting. Indeed, probably closed enough to put September firmly on the table. But will they lay down any markers? They’ll likely not add language that promises a hike in September; they want to conduct policy on a meeting-by-meeting basis. But be on the watch for any change in the statement that might point to an increasing confidence that the economy is on the right track. That would be a good signal that September is alive and well.
The author is the professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy’s Fed Watch.