Monetary Policy Outlook

The minutes of the October 28-29 Federal Open Market Committee meeting suggested that there is still no consensus opinion among senior officials regarding when the Fed will begin raising short-term interest rates. There is strong agreement that monetary policy moves will be data-dependent. However, policymakers differ in their views on the amount of slack in the job market. Only “a few” Fed officials expressed concerns that inflation might persist below the Fed 2% target. However, while survey-based measures of long-term inflation expectations had remained stable, “market-based measures of inflation compensation had declined somewhat.” While this bears watching in the U.S., it’s a much bigger worry for the euro area.

“Indicators of labor market conditions continued to improve over the intermeeting period, with a further reduction in the unemployment rate, declines in longer-duration unemployment, strong growth in payroll employment, and a low level of initial claims for unemployment insurance. Business contacts reported employment gains in several parts of the country, with relatively few pointing to emerging wage pressures, although one participant indicated that larger wage gains had been accruing to some individuals who switched jobs. Labor market conditions indexes constructed from a broad set of indicators suggested that the underutilization of labor had continued to diminish, although a number of participants noted that underutilization of labor market resources remained. A couple of participants judged that the large number of individuals working part time for economic reasons and the continued drift down in the labor force participation rate suggested that the unemployment rate was understating the degree of labor market underutilization.” 
– FOMC Minutes (October 28-29)

The labor market slack debate has grown in recent weeks. One issue is how to weigh the various measures. The Kansas City Fed’s Labor Market Conditions Index provides a handy summary. The LMCI suggests that slack is being taken up, perhaps a bit more rapidly in recent months. However, it also indicates that a lot of slack remains. Other parts of the debate focus on which measures of slack matter more. Currently short-term unemployment (those out of work for six months or less) is trending low (at a level which we would normally associate with a job market that is running at full steam). Longer-term unemployment (more than 6 months) has been trending lower, but remains relatively high by historical standards. Some economists have argued that long-term unemployment is largely irrelevant to the inflation outlook. Last week, New York Fed economists argued that it does matter. There are enough people on the sidelines (not officially counted as “unemployed,” but who would still take a decent job if one were offered) to keep wage pressures relatively muted.

The major surprise in the October 29 policy statement was the absence of concern about low inflation. In policy statements in the first half of this year, the FOMC noted that “inflation persistently below the 2% objective could pose risks to economic performance.” This sentiment was missing from the October policy statement, but also from the FOMC minutes. Many economists had expected that the current low trend in inflation and downward inflationary pressure coming from the rest of the world would lead to a delay in the first Fed rate hike.

Inflation Compensation, the spread between fixed rate and inflation-adjusted Treasury securities, is not an exact measure of inflation expectations. However, recent values suggest a lower inflation outlook over the next five years and over the five years after that (the five-year rate five years forward).

As inflation expectations fall, real interest rates rise, which has a negative impact on growth. Nominal interest rates can’t be lowered. This isn’t a big concern for the U.S. economy just yet, but it is a critical problem for the euro area, where the economy is much weaker than in the U.S.

© Raymond James

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