There is a very good probability, perhaps 60 percent, that the Federal Reserve (Fed) will move at its April 28-29 or its June 16-17 2015 Federal Open Market Committee (FOMC) meeting to abandon its zero-rate policy. There is a very small chance (5 percent or less) that the decision to raise short-term rates could come earlier, and a 35 percent probability of the decision being postponed into the second half of 2015 or even later. Interestingly, the defining issue is the sustained low pattern of core inflation and not the state of United States labor markets. Moreover, international and energy market concerns both play to sentiment inside the FOMC to delay the decision, since they suggest further deflationary pressure.
Hourly wage growth to pick up incrementally in 2015
As the unemployment rate has steadily ticked downward over the last five years of economic expansion, a key lingering concern has been the slow rate of hourly wage growth. In the last part of the tech-boom of the 1990s, hourly wage growth peaked at around 4 percent annually, and it reached this 4 percent level again in 2006-2007 at the end of the housing boom. Following the 2008-2009 recession, hourly wage growth slid below 2 percent annually. Hourly wage growth remains very sluggish. We think hourly wage growth will move toward 3 percent annually by mid-2016. However, this pace will be disappointing to many FOMC members, and they will advise to delay any short-term rate rise decision.
Hourly wage growth is not a useful indicator of future inflation
Some FOMC members, including Fed Chair Janet Yellen, also look to a pick-up in hourly wage growth as a sign of possible future inflationary pressure at the consumer price level. There may have been some statistical evidence for this view in the late 1960s and 1970s, but over the last 20-plus years there has not been any correlation worth noting between core consumer prices and hourly wages. What we do see is that core inflation provides a kind of “soft” floor for hourly wage growth in the years after a recession when hourly wage growth typically declines. Eventually, the spread of wage growth over core inflation starts to widen late in an economic expansion. That pattern may be in play this time around, but hourly wage growth is being held back by the very strong competition from imported goods, among other factors.
International headwinds remain
On the global scene, oil prices have fallen off a cliff, the U.S. dollar has been relatively strong, the Chinese economy is still decelerating (albeit growing at 6-7 percent for 2015), and emerging market real GDP growth is mostly positive, yet quite modest and uneven. Against this backdrop, the U.S. economy has done quite well, yet many FOMC members will be reluctant to move rates higher so long as these global headwinds remain as strong as they are.
Removing emergency policy measures
The strongest argument for abandoning the zero-rate policy is simply that an economy that has reeled-off five years of modest economic growth no longer needs emergency policy measures, such as quantitative easing or short-term rates below the prevailing rate of inflation. The Fed has a long history with several episodes of remaining too loose, too long. Our base case view is that, absent some major global economic disruption, by June 2015 a majority of FOMC voting members will be willing to push short-term rates upward – more or less to the same level as the core inflation rate, and then they will call a halt to further rate rises and wait and see what happens to the U.S. economy, the dollar, inflation, and labor markets. Please note that the rate rise may come in bigger steps than mere 0.25 percent increments, and that the key enforcer of higher short-term rates will be an increase in the interest rate paid by the Fed on excess reserves, which is now 0.25 percent.
Read Blu Putnam’s full 2015 U.S. outlook here.