A tough job for the Fed in 2014

Low inflation should allow the Fed to hold off tapering until at least March. But coupled with a labour market still 8 million jobs below target, it also underscores the painfully slow pace of recovery.

Unlike in September, there were no surprises from the US Federal Reserve meeting held overnight. But soft CPI and private payrolls data also showed how far the US recovery has to go.

The Federal Open Market Committee decided to continue its $US85 billion ($89.36 billion) monthly asset purchasing program. This includes purchasing $US40 billion of mortgage-backed securities and $US45 billion of longer-term, Treasury-backed securities per month.

The Fed said it would continue its purchases until the outlook for the labour market improved substantially, and that the federal funds rate would be held between 0 to 0.25 per cent, as long as the unemployment rate remains about 6 to 6.25 per cent. Currently the unemployment rate is 7.2 per cent; however, this overestimates labour market conditions given labour market participation is at its lowest level in 30 years.

The committee said that asset purchases were not on a preset course and were contingent on its economic outlook. The March meeting is set to be the next genuine opportunity to begin tapering as the Fed will have access to very little untainted economic data over the next few months.

Importantly for Fed policy, inflation remains well anchored and is unlikely to rise rapidly in the near future. In September, headline CPI rose by 0.2 per cent, to be 1.2 per cent higher over the year. The Fed’s preferred gauge of inflation, the personal consumption expenditures index, was also up 1.2 per cent over the year. Both results were well below the Fed’s target of 2 per cent inflation. The Fed indicated that it expects inflation to rise over the next two years.

However, while low inflation and well-anchored inflation expectations allow the Fed to continue with its policies, they also underscore the slow and painful US economic recovery. Typically, we would expect growth in both GDP and employment to be much higher at this point of the recovery.

US private sector payrolls are estimated to have increased by 130,000 in October, according to ADP. This was the second smallest gain this year, but reflects only private sector employment and not the shutdown-affected government sector. Consequently, the rise in non-farm payrolls is set to be much lower in October and the unemployment rate will probably rise a little towards 7.4 per cent.

As a rule of thumb, the US labour market has to grow at around 100,000 per month simply to keep track with population growth. 

To put this into perspective, non-farm payrolls remain around 1.7 million below where they were in December 2007, when the global financial crisis began. Add in population growth since then (around 100,000 per month) and the US labour market is around 8 million to 8.5 million jobs below what economists would term ‘full employment’. Once you account for the aging population, the shortfall is a little smaller than that but is still a startlingly high number, highlighting just how long it will take for the US to get back to normality.

The next few months are going to be particularly interesting for the US. The budget battles in Washington will set up the US economy for 2014. A smooth budget process would go some way to helping relieve uncertainty in the broader US economy. I anticipate that the negotiations will not be as dramatic as those in September and October, but policy makers will still wait until the last minute to make a decision.

I mentioned two days ago that uncertainty in the US may result in the Reserve Bank of Australia delaying an interest rate move (The RBA’s rebalancing act rests on Fed action, October 29). One positive is that the Australian dollar has continued to decline to be below 95 US cents after our central bank governor Glenn Stevens’ speech on Tuesday. But for now the RBA is set to remain in a holding pattern, awaiting more information.

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