December Still A Go, by Tim Duy: Some back of the envelope calculations: The Fed's long-run real GDP growth estimate – the rate of potential GDP growth – is 1.8%. According to Federal Reserve Vice Chair Stan Fischer last week:
If labor force participation was to remain flat, job gains in the range of 125,000 to 175,000 would likely be needed to prevent unemployment from creeping up. However, if labor force participation was to decline, as might be expected given demographic trends, the neutral rate of payroll gains would be lower. If we assumed a downward trend in participation of about 0.3 percentage point per year, in line with estimates of the likely drag from demographics, job gains in the range of 65,000 to 115,000 would likely be sufficient to maintain full employment.
Labor force growth of 0.3%. Together, these two points imply a productivity estimate of 1.5%. The Fed's inflation target is 2%. The 2% inflation target plus 1.5% productivity growth suggests that the Fed anticipates wage growth of 3.5% when the economy settles into full employment.
Roughly; these are just back-of-the envelope calculations. Notice though that the 3-month moving average for average wage growth ticked up to 3.3% last month:
To be sure, 12-month wage growth still lags at 2.8%, but you can see where that trend is headed. Just like inflation, headed higher.
Under these conditions, it is reasonable to believe the economy is very close to full employment. Of course, some slack may still lurk in the background. Perhaps it exists in the underemployment estimates:
Or perhaps labor force participation will feel more cyclical pull before demographics begin to dominate again. But that would be a short-term impact. Longer run, the aging population will take its toll on the labor force. Anyway you slice it, the Fed's comfort level with their estimate of full employment must be on the rise:
Indeed, given the current pace of job growth, the Fed anticipates the economy is positioned to soon reach their mandates. Perhaps even more so. Fischer from last week:
…the more interesting and important questions relate to the next few years rather than the next few months. They relate in large part to the secular stagnation arguments that were laid out yesterday in Larry Summers' Mundell-Fleming lecture–in particular the behavior of the rate of productivity growth. The statement that the problem we face is largely one of demand–and we do face that problem–seems to imply either that productivity growth is called forth by aggregate demand, or a Say's Law of productivity growth, namely that productivity growth produces its own demand.
That is not an issue that can be answered purely by theorizing. Rather, it will be answered by the behavior of output and inflation as we approach and perhaps to some extent exceed our employment and inflation targets.
The Fed faces a familiar dilemma in December. Act preemptively, or hold still waiting for labor force and productivity growth to comes along? Most likely the Fed will take the opportunity in December to act preemptively and reiterate that doing so allows for them to retain their “move gradually” plan.
Does the election throw a wrench in their plans? Financial markets were buoyed by the prospect of a Republican dominated government, sending stocks higher and bonds lower. Would the bond sell off induce the Fed to take a pass in December, on the theory that higher interest rates imply tighter financial conditions? In this case, I think not. The steepening of the yield curve:
likely reflects the prospect of a reflationary policy mix. Note also that market-based inflation expectations tell the same story:
The Fed finally has the chance to chase the yield curve higher; I think they take it.
The situation differs from the steepening of the infamous “taper tantrum.” Then the sell-off on the long end reflected a perceived change in the path of monetary policy, a perception the Fed did not share. Hence they needed to act in such a way to communicate their true intentions. In this case, the market is digesting new developments and raising estimates of the medium-run economic outlook and the likely monetary policy path.
Note that the Fed sees the prospect of fiscal stimulus as well. Fischer again, via Reuters:
“On more expansionary fiscal policy, I think many members of the open market committee and of the Federal Reserve Board have commented it would be useful to have a more expansionary fiscal policy,” Fischer said.
It is not exactly a secret that the Fed would like a more expansionary fiscal policy to take on more of the macroeconomic policy burden. The Fed believes that a more expansionary fiscal policy would provide them greater room to “normalize” interest rates. Hence they will be closely watching the evolving fiscal agenda. It is too early for them to update their economic projections dramatically, but with regards to the December rate decision, the prospect of substantial fiscal stimulus must count as an upside risk for growth and inflation.
Given that the economy is already near the Fed's estimates of full employment, the risk of fiscal stimulus should imply a risk of a higher rate path in 2017 and beyond. Assuming no change in productivity or labor force growth, it is reasonable to anticipate that the Fed would consider a full monetary offset to any fiscal stimulus; the alternative from their perspective would be substantially higher inflation. President-elect Donald Trump might not take too kindly to such an agenda, thinking that it would undermine his efforts to
“make America great” again. The risk is that he would attempt to further politicize the Fed, nominating friendly governors willing to minimize the monetary offset. Beware of higher inflation in such an environment.
Bottom Line: With the economy hovering near full employment, the Fed will want to press forward with a December rate hike. Market odds of 85% are reasonable. Watch for signs the Fed will feel they have little choice but to offset fiscal stimulus if they want to preserve their inflation target. This is particularly the case for any large stimulus; Republican administrations have historically been pro-deficit spending. The stage is set for a contentious relationship with the next Administration. Watch for increasing politicization of the Federal Reserve.