The Fed’s next focus is on wages
by Gavyn Davies
A few weeks ago, this blog advanced the theory that the behaviour of the major central banks, which had dominated market attention for so long, would not be the decisive element for asset prices in 2014. With the Fed, the Bank of England and the ECB all increasingly doubtful about the effectiveness of further growth in their balance sheets, the central banks had become much more circumspect about how much more monetary policy could achieve. Supply side pessimism was gaining ground.
So far, so good for this theory. The Fed has embarked upon “tapering by auto pilot”, and seems increasingly satisfied with its handiwork. A moderate recovery in GDP growth, along with much diminished risks of financial market disruption, is sufficient. They are in no hurry whatsoever to reduce the size of their balance sheet, and that could yet cause trouble; but nor do they show much urgency to return the US economy to its long term output trend.
Emergency policy interventions like QE3 in 2012 have been replaced by an atmosphere of calm. Following the example of the medical profession, they seem to have decided: “first, do no harm”.
As a result, the markets’ expectations for interest rates have become more stable, and are now almost exactly where the central banks would want them:
The path for forward short rates in the US is precisely in line with the median forecast of FOMC members. The ECB’s promise of an “extended period” for near-zero rates, followed by a very gradual rise thereafter, is also very apparent. In the battle to tame the markets’ short rate expectations, which raged at times last year, the central banks have decisively been declared the winners.
That is no bad thing. The period of monetary shock and awe was fascinating for macro-economists, but it scarcely signalled that the global economy was in a healthy condition. Now that the developed economies seem to be returning to normal, the central banks are becoming more boring again. They are rock stars no more.
Where next for the Fed?
The US economy has been significantly affected by bad weather for several months, but otherwise seems to be growing slightly above trend, as had been widely expected.
New York Fed President Bill Dudley said last week that it would take a major change in his perception of GDP growth to induce any change in his view about tapering, adding that he thought that underlying growth in the economy was still in the vicinity of about 3 per cent. In this, he probably spoke for the vast majority of the FOMC, including Janet Yellen, and the latest “nowcast” data (see graph) also support his view.
Significantly, he indicated that he was satisfied with the markets’ expectation that the first rise in the short rate would come in mid or late 2015.
We have known for a while that a couple of hawkish participants at the FOMC (eg Charles Plosser and Jeffrey Lacker) have wanted to raise rates as early as this calendar year, and that others (Jeremy Stein, Richard Fisher and Daniel Tarullo) are becoming more concerned about bubbles in asset prices. But it is interesting to hear a prominent dove like Bill Dudley accept that rates should begin rising about 18 months from now.
It is likely that one or two of the most dovish outriders on the committee (Eric Rosengren and Charles Evans, for example) still see a case for a much longer period of zero rates, perhaps stretching well into 2016. But at the moment that is very much a minority view, with the bulk of the committee apparently comfortable with the expectation that a gradual increase in rates will begin next year.
The splitting of the centrist group of moderate doves from the arch doves is a notable development, which may change the balance of risks compared to previous years. Until recently, the basic rule has been “never underestimate the dovishness of the Fed”. Now, a more hawkish path for forward rates than that built into the forward curve seems conceivable, though that will depend on events.
In the near term, Bill Dudley said that the Fed would soon have to eliminate the 6.5 per cent unemployment rate threshold, and he added that he saw advantages in the Bank of England’s new framework, under which a large number of different measures would be used to assess the tightness of the labour market. This new BoE framework is the latest flavour of the month, and it will probably be endorsed at the next FOMC meeting on 18-19 March. In effect, it ditches forward guidance in favour of maximum flexibility to respond to future events, and is another sign that policy is normalising.
Wages will be judge and jury
In the longer term, it is likely that wages will emerge as the indicator that matters most for the FOMC. In the ongoing debate about how much spare capacity is left in the labour market, the behaviour of wages is increasingly being viewed as decisive.
Paul Krugman points out that there is no sign yet of any generalised increase in wage inflation, and argues that the Fed should not even consider tightening until wage inflation is back to its pre-crisis rate of almost 4 per cent per annum. The arch doves on the FOMC probably agree with him. But Tim Duy’s Fedwatch says that any rise in wage inflation above 2 per cent will quickly worry the Fed, which has always in the past started to raise rates as soon as this threshold has been reached. That is probably what the bulk of the FOMC now thinks.
So there we have the likely shape of the next major controversy about Fed policy. Ms Yellen’s view on this is not yet known, but her public statements so far have clearly been designed to reflect the centre ground on the FOMC. Any sign of a general rise in labour costs could bring forward the date of the first rate rise.
Markets should therefore watch the monthly wages data even more closely than they watch the non farm payrolls in future.
To misquote James Carville: “It’s wage inflation, stupid!”