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WEEKLY ECONOMIC COMMENTARY -- WEEK OF FEBRUARY 24, 2017

 

The odds that the Federal Reserve will hike interest rates before mid-year has been increasing for several weeks, thanks to stronger-than expected economic data as well as the pick up in some key inflation measures. Heading into February, the consensus forecast was that the next rate increase would not be implemented until June, giving the Fed time to assess economic conditions over the first half of the year and perhaps get a clearer picture of the timing and substance of the fiscal policy initiatives coming out of Capitol Hill. The latter part remains as murky as ever and we would be surprised if any tax or spending measures are finalized before the second half of the year, if then. But the Fed appears to have been surprised by the economy's momentum, and seems receptive to speed things up.

That perception, buttressed by Janet Yellen's semi-annual monetary policy testimony discussed last week, received another boost this week with the release of the minutes of the January 31-February 1 policy meeting. At that confab, "many participants" said they thought another rate increase would be appropriate "fairly soon", reaffirming chair Yellen's assertion that a rate increase was likely in "coming meetings". Keep in mind that the meeting was held before the raft of data portraying firming conditions in January was released, which included data on employment, retail sales, production, homebuilding and inflation, all of which exceeded expectations. Simply put, some of the hard data is starting to confirm the post-election euphoria that has driven household and business sentiment to elevated heights.

That said, it is unclear if most Fed officials are convinced the economy's performance will live up to these heightened expectations. According to the minutes, the median forecast of economic conditions made at the December meeting has not changed, so the same could be said for the planned three rate hikes set forth at that meeting. True, the strength shown in recent weeks has probably generated a more hawkish bias in the minds of some policy makers, increasing their willingness to pull the rate trigger sooner rather than later. There is even some talk that the upcoming March 14-15 meeting is "on the table" as a possible launching date. However, the Fed funds futures market still considers that a long shot, pricing the odds at about 20 percent.

We concur with those small odds, but recognize that some key economic indicators will be released prior to the mid-March meeting, which could move the needle in the hawkish direction. If the upcoming employment, retail sales and inflation data again exceed expectations by a wide margin, the concern about overshooting the inflation and unemployment targets could gain more support. From our lens, however, the data would have to be compelling and decisive to prod the Fed to act so soon. The more likely response would be that the next rate increase is pushed forward from the expected June to the May policy meeting. Indeed, the fed funds futures market on Friday put the odds at 52 percent for a May hike and 70 percent at the June meeting, which is roughly line with our assessment.

Keep in mind that while the data for January have mostly exceeded expectations, some of the strength - particularly for retail sales - may have been weather-related. If the exceptionally warm and mild winter so far pulled forward some sales, the payback may show up in weaker retail activity in coming months. The Fed is probably on the right track by not altering its economic forecast until the recent strength is validated by another month or two of data. The sturdy gains in employment and rising incomes suggest that consumer spending will remain on a moderately strong path. But the setback in wage growth revealed in the January employment report also suggest that the tightening labor market has not enhanced worker bargaining power much. Indeed, it leaves open the question of just how much slack there actually is the work force.

While the unemployment rate has been driven down to under 5 percent, a rate historically consistent with full employment, other measures indicate that there is still some slack in the labor force. The broader underemployment rate at 9.4 percent, which includes part-term workers that would prefer full-time positions, is still about 1 percentage point above prerecession levels. Then, of course, there is the low labor force participation rate, which underpins the belief by policy doves that letting the economy run hotter for a while would draw some workers back into the labor force. That is, stronger demand would create more supply of labor, thus countering upward pressure on wages and, hence, inflation. Indeed, the January employment report provided a snapshot of that scenario. Despite a stronger-than-expected 227 thousand increase in payrolls, both the unemployment and labor force participation rates ticked up, indicating that some workers are being lured off the sidelines.

To be sure, just as the low unemployment rate overstates the degree of tightness in the labor market, the low participation rate exaggerates the amount of slack there is. The share of the working-age population either holding a job or looking for one has been on a declining trend for decades due to a variety of reasons. The biggest influence, particularly in recent years, is the aging of the population, which is pushing about 10 thousand workers a day into the over-65 category typically associated with retirement. This persistent demographic trend is something that monetary policy is powerless to reverse. Ironically, however, the aging of the population had little effect on the participation rate over the past year. Indeed, the decision of more geezers to opt in rather than drop out was one of the few forces that actually propped up the participation rate in 2016.

Unlike the broader participation rate, the share of older workers (over 65) in the labor force has been on a steady uptrend since the late 1990s, reflecting, among other things, weakening age discrimination barriers, better health among older workers, the desire to beef up inadequate retirement savings and the increasing dominance of service jobs in the economy that require less physically demanding labor. However the rising trend peaked at 19.2 percent in May 2013 and then drifted lower to 18.3 percent in August 2014. A mild upward move took hold over the following year before jumping in 2016, reaching a new high of 19.5 percent in March, where it continued to hover until late in the year. The rate dipped to 18.8 percent in December but rebounded to 19.1 percent in January of this year.

It remains to be seen if the older population continues to increase its participation in the labor market, thus muting the impact of demographic forces. It's not likely though that the Fed considers the nonworking segment of the population that is over 65 as potential reentrants to the labor force. Instead, Chair Yellen has often cited the elevated level of involuntary part time workers as an indication that there is still slack in the labor market. In January, this segment of the workforce stood at 5.8 million. That's down from a cycle high of 9.2 million but still about 1.5 million above prerecession levels. Yellen believes that letting the labor market run a bit hotter would get more of these part timers into full-time positions.

But more troublesome and less understood is the decline in the share of prime-age men, those who fall in the 25-54 year old category, that are gainfully employed. This trend, which removes retirees from the picture, has been on a downward slope for decades, reflecting broader access to government disability insurance programs and the proliferation of two-income earners in households, among other reasons. Still, there is a cyclical component to the trend, wherein the decline accelerates during recessions and recovers most of the way back during recoveries. This time, however, prime-age men have only clawed back about two-thirds of the jobs lost during the recession, a much smaller rebound then in past recoveries. This suggests that at least some of the prime-age workers on the sidelines, particularly low-skilled workers, would return to the labor force if growth were stronger.

Our sense is that there is little risk associated with erring on the side of moving too gradually to normalize interest rates. Even if actual growth exceeds the economy's potential growth rate in the first quarter that should not stoke fears the economy is overheating or poised for an uncontrollable inflation outbreak. For one, the economy has not put together two consecutive quarters of growth that exceeds 2 percent since 2014. It's far from certain that threshold will be accomplished over the first half of this year, albeit we are cautiously optimistic that it will. For another, while the prospect of fiscal stimulus may make some Fed officials receptive to an earlier rate increase, others may be deterred by the potential growth-retarding impact of the administration's trade and immigration proposals. We still believe that the odds favor only two rate increases this year beginning in June, but a May hike is certainly possible and a third increase could well occur if incoming data continue to exceed expectations