A funny thing happened on the way to the Fed’s plans to raise interest rates this year: The data failed to cooperate.
Key inflation and wage data are defying policymakers’ predictions, either by falling outright or failing to rise despite better growth and jobs numbers. The data present a challenge to the conventional wisdom in the markets and on the Fed for a rate hike this year. Simply put, with declining inflation and flat wage gains, why exactly would the Fed hike rates?
What’s happening now appears to be the flip side of the monumental events in the 1970s when inflation, defying theory, headed up while unemployment rose at the same time. Now, unemployment has fallen but wages are also falling with a surprising 0.2 percent decline reported for December. And inflation is struggling to stay at 1.5 percent, consistently below the Fed’s 2 percent target.
At issue is a long-debated topic among economists of what exactly is the dynamic that causes inflation, how much monetary policy can influence that dynamic, and just how much unemployment and inflation really have to do with each other, if anything at all.
Our knowledge of the inflation dynamic “is less than we would like and less than we need, given where we in the cycle,” Columbia University professor Richard Clarida, one of the world’s leading experts on monetary policy, said in an interview.
Since the Fed launched the third round of bond purchases, or quantitative easing, the unemployment rate has fallen from 7.8 percent to 5.6 percent. Over that time, the core inflation rate (taking out food and energy) has remained virtually unchanged at 1.5 percent. Wage gains have also not budged, and even fallen from their already anemic annual gains of 2 percent. So, a much tighter job market, as measured by the unemployment rate, or even the number of jobs created, has failed to increase wages or spark any inflation in the economy. Ditto for the inflationary effects of trillions of dollars in Fed bond purchases.
If that’s the case, why exactly would the Fed raise rates?
Lou Crandall, Fed observer at Wrightson ICAP, thinks the Fed “will have to see an appreciable pickup in wages” before raising rates. He believes the surprising December decline will reverse in January, but will have to rise further to confirm a rate increase.
Getting it wrong has consequences for the Fed. The Fed faces a potential loss of credibility in its ability to hit its 2 percent inflation target. So-called “five-year, five-year forwards,” which try to tease from market prices longer-term inflation expectations—fell to the lowest level since 2011 last week, hovering around 2 percent. For most of last year, it was usually above 2.5 percent. Near-term inflation expectations, over the next five years, are even lower at just 1.2 percent. That’s a sign that the market is beginning to doubt the Fed’s ability to hit its own target.
The Fed will clearly not hit the panic button on the single wage number from December. But Atlanta Fed President Dennis Lockhart said this week that “the behavior of wages and prices … remains less encouraging, and, frankly, somewhat puzzling in light of recent growth and jobs numbers.”
Both Lockhart and San Francisco Fed President John Williams say they still see the first rate hike coming in the middle of the year. Lockhart said he expects the inflation data to be soft in the first half of the year because of lower oil prices and move toward the Fed’s 2 percent target in the second half.
But he added, “Inflation readings and forecasts may be pivotal in deciding when to begin adjusting policy. … We are, at present, experiencing inflationary trends well below target, and our readings are complicated by more-than-normal noise associated with the drop in oil and gasoline prices, falling import prices, and softening of some measures of inflation expectations.”
Attention on Thursday will turn to the Producer Price Index, which is expected to fall 0.4 percent, and rise a 0.1 percent when excluding food and energy. Economists forecast the same numbers for consumer prices on Friday (down 0.4 percent on headline and up 0.1 percent ex-food and energy.)
The key for the Fed is whether the decline in energy prices shows up in broader price drops inside the core. More interesting could be the upcoming release of the Employment Cost Index for the fourth quarter on Jan. 30. It hit a post-recession high in the third quarter with a 2.26 percent year-over-year gain. While that did represent two-straight quarterly gains, the current level is below the worst gains in the 25 years before the Great Recession, which is to say, that by historical standards, wage gains remain muted.
Clarida said the Fed could raise interest rates only because of an institutional desire to no longer remain at zero. But he also thinks wage gains should be allowed to run as there is a long way to go for workers to recoup what they haven’t gained in the recovery from the Great Recession.
Nobel Prize winner Ned Phelps thinks the Fed should stay on course to raise rates. He believes wage gains could be muted by the retirement of older workers at higher salaries being replaced by younger workers at lower salaries. That temporary process shouldn’t stay the Fed’s hands in normalizing rates, Phelps said.
A rate hike this year still seems likely, given comments by Lockhart and Williams. But unless the Fed more explicitly describes its thinking, it’s going to have trouble explaining to the public why those rate hikes are necessary