Yellen’s Testimony Today, and the Second Mandate

“… the economy has made further progress toward the Federal Reserve’s objective of maximum employment, while inflation has continued to run below the level that the Federal Open Market Committee (FOMC) judges to be most consistent over the longer run with the Federal Reserve’s statutory mandate to promote maximum employment and price stability.”
-Janet Yellen

It’s hard to argue that the labor market hasn’t improved dramatically over that past several years. The unemployment rate is down to 5.3%, compared to a financial-crisis high of about 10%. The economy created an average of about 260K jobs per month in 2014, and the monthly pace so far this year is about 208K. Weekly jobless claims are way down, job opportunities have increased, and more people are working. This is all good news.

But this is not to say there aren’t continued problems in the labor market. The labor participation rate remains at a decades-low level; middle-class income growth remains very weak; part-time jobs are replacing full-time jobs (with benefits); and low-paying services jobs have replaced manufacturing jobs. So, progress but not perfection. But the continued progress is making it increasingly more difficult for the Fed to justify holding interest rates at emergency levels much longer.

At this point, we think the Fed may be more troubled by inflation, which is the second of the central bank’s dual mandates. In the table below we show some of the key inflation metrics that the Fed uses in the formulation of monetary policy. Two of the metrics – the Personal Consumption Expenditures deflator (PCE) and the Consumer Price Index (CPI) – cover consumer goods and services. Consistent with the Fed’s practice, these metrics exclude prices for the volatile categories of food and energy. These two metrics have been running well below the Fed’s target of about 2.0% over the past three years, with the most recent readings trending even lower. This has given the Fed cover to keep rates lower for longer.

But perhaps the more important numbers for the Fed at this stage are the other two inflation metrics, the Employment Cost Index and Average Hourly Earnings. These two metrics gauge the level of employment compensation, and they are important because higher incomes generally lead to higher demand for goods and services, and therefore higher price levels. The most recent reading for the ECI, which is the only of the four metrics reported quarterly, came in at 2.6% for the first quarter of 2015. Following the release of this figure on April 30, speculation increased dramatically that the Fed would begin to hike interest rates soon so that it would not get “behind the curve” in defending against more widespread inflationary pressures. In the two weeks following that April 30 report, the yield on the 10-year Treasury bond increased from about 2.03% to 2.29%. The yield continued upward over the next month, hitting a recent high of about 2.49% on June 10. Importantly, though, none of the other inflation metrics have confirmed the upward spike in the first-quarter ECI. In fact, the most recent reading for average hourly earnings (for June) was a very disappointing +2.0% reported on July 2. Treasury yields dropped significantly after that report.

23add351-6f44-46dc-baa2-79f2081aa483Source: Bureau of Labor Statistics and the Bureau of Economic Analysis

Below we show one of the current drags on inflation rates in the US – import prices. A spike in the value of the dollar versus major trading partners has resulted in lower import prices. These increases in the dollar, in turn, have generally been caused by one of two factors. First, fear of crises outside the US (China, Greece, Iraq, Syria, Ukraine, you name it) generally cause a “flight-to-safety” trade, which means buying the dollar and dollar-denominated assets. Second, traders buy the dollar due to the perception that the US economy is strong relative to the rest of the world, and that the Fed is therefore on the verge of raising interest rates. Ironically, though, if the Fed starts to raise rates soon, the dollar will rise further and lead to more pressure on import prices. It’s a catch-22.

787a2c42-84f4-4d85-9d4b-a70f160df6dcBureau of Labor Statistics and the Bureau of Economic Analysis

So, what is our conclusion? We suspect that unless the spike in the ECI for the 1Q is confirmed by future inflation readings (unlikely at this point), the Fed will either 1) defer the first rate hike until next year; or 2) make one symbolic raise and then pause indefinitely. The weakness outside the US is simply too great right now for the Fed to start tightening alone, if for no other reason than the reaction in the currency markets.