Is the Fed Behind on Tightening? Watch This Inflation Indicator

  • Construction, manufacturing resurgence may lift June hike odds
  • Watch effect of jobs data on market measure of inflation risk

With investors already banking on the Federal Reserve lifting interest rates next week, attention has shifted to whether the central bank has fallen behind in its quest to keep inflation from rising too quickly.

The answer will become clearer Friday when the February jobs report lands at 8:30 a.m. in Washington. While the reaction in fed funds futures will tell a large part of the tale, keep an eye on the spread between yields on five- and 10-year U.S. Treasury notes to gauge how investors are thinking about longer-term inflation risks.

The spread has narrowed over the last two weeks as Fed policy makers have talked up the possibility of a March rate hike, suggesting investors don’t believe for now that the central bank risks falling behind the curve with regard to inflation. The difference, at about 47 basis points, dipped into negative territory near the end of the Fed’s previous two hiking cycles.

The narrowing gap "points to a decline in inflation risk, which is a function of whether policy is loose or tight," said Vince Foster, a portfolio manager at Southern Bancorp in Little Rock, Arkansas. "If the Fed were truly behind the curve on tightening policy, these markets would be pricing in elevated inflation risk premiums."

The jobs report is expected to show employers hired 200,000 workers last month, according to the median estimate of 85 economists polled by Bloomberg. Growth in average hourly earnings is expected to have accelerated to 2.7 percent, from January’s 2.5 percent pace.

Investors have good reason to be on guard. A report published Wednesday by ADP Research Institute in Roseland, New Jersey, suggests those estimates may be too low. It showed private-sector employers added 298,000 workers to payrolls in February, marking the biggest monthly gain in nearly three years. Goods-producing industries led the way with the largest surge in employment on record in 15 years of data, on strength in construction and manufacturing.

Construction and manufacturing are two above average wage sectors of the economy that have seen a significant slowdown in job growth over the last year or two. A turnaround in the Labor Department data of the kind the ADP data hint at would probably give the Fed further confidence to follow up a rate hike this month with another this summer.

Even if Friday’s report is unlikely to change the odds of a rate hike next week, the implications for Fed officials and their plans for the rest of the year will be apparent in the market for futures contracts tied to the U.S. central bank’s benchmark federal funds rate.

If strong data lead investors to believe an additional hike sometime at one of the Fed’s next three meetings in May, June and July is more likely, the yield implied by the August federal funds futures contract will move closer to 1.16 percent, where the rate would settle following another increase. Right now, the spread between the rates implied by the April and August contracts implies roughly two-to-one odds of an increase over the summer.

Those odds are down slightly from where they were two weeks ago, before Fed officials signaled that a March rate hike was probable, whereas investors had previously seen such a development as unlikely.

The reaction of inflation-protected Treasury yields to the report could also contain clues as to whether investors agree with the Fed’s normalization plans. Should a disappointing number spark a sharp decline in so-called real rates, it could imply that investors are worried that the telegraphed March hike represents a policy mistake that risks snuffing out the expansion. Conversely, an increase in inflation-protected Treasury yields amid resilience in equities would suggest that the central bank has more room to continue its tightening cycle without markets worrying about an imminent recession.

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