In just a few weeks the Federal Reserve’s asset purchasing program will be complete, but, it will be a “considerable time” before rates rise. It will almost certainly be next year -- consistent with current Fed forecasts -- but there remains some uncertainty surrounding the timing.
Rate normalisation dominated the Fed’s September meeting and expect more of the same when it meets at the end of October. But the Fed continues to maintain that, “it likely would be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends.”
A lot will depend on developments in the labour market and how that feeds through to inflation and inflation expectations. The unemployment rate fell to 5.9 per cent in September and -- if you remember back to earlier this year -- the unemployment rate is now at a level where the Fed has previously stated it would consider raising rates.
Non-farm payrolls increased by 248,000 in September, with estimates for July and August revised up significantly (US employment’s soft underbelly, October 6). Annual job growth is now at its highest level since April 2006 and, if the recent trend can be maintained, the labour market appears set for its strongest year since 1999.
But it is inflation that is holding the Fed up and that may not change in the near term. According to the Fed, “most participants anticipated that inflation would move gradually towards its objective [2 per cent annual inflation] over the medium term.”
So far inflation has responded only modestly to rising employment, although “businesses in several districts continued to report upward pressure on wages in specific industries and occupations.” The core personal consumption expenditure (PCE) deflator -- the Fed’s preferred measure of inflation -- has increased by just 1.5 per cent over the year to August.
The relationship between employment and wages is somewhat uncertain at the moment. Normally an unemployment rate of 5.9 per cent would be sufficient to create moderate wage pressures but there remains considerable spare capacity across the US that suggests that the labour market is somewhat weaker than the headline labour force estimates imply.
As I’ve noted previously, many of the new jobs created have been part-time or low-paying positions, which may also be contributing to soft wage growth and inflation. But if the recent job growth proves persistent -- pushing the unemployment rate to say 5.5 per cent by March next year -- then it is difficult to see wages and inflation remaining in their current rut.
One important factor for upcoming meetings will be how the market responds to the end of the Fed’s asset purchasing program. It’s also worth noting the Fed’s heightened concerns regarding the international economy.
The US dollar has appreciated significantly in recent months against their major trading partners and some participants “expressed concern that the persistent shortfall of economic growth and inflation in the euro area could lead to a further appreciation of the dollar and have adverse effects on the US external sector.”
The rising dollar will also weigh on inflation and could potentially push back the timing of the Fed’s first rate rise. But it is also worth noting that the US is not as trade-exposed as many other countries and the effect of the dollar on inflation may prove only moderate.
The housing market also remains an area of concern and obtaining credit continues to be difficult for many households. Younger households in particular continue to be weighed down by poor credit scores and high levels of student debt.
US economic data since the Fed’s September meeting has generally been quite positive, particularly in the labour market. The Fed will complete its asset-purchasing program when it meets at the end of this month and then the market will turn its attention to rate normalisation.
If employment growth can maintain its recent growth then I’d expect the Fed to lift rates in the first quarter of 2015. But clearly there is a lot of uncertainty and much that could potentially go wrong between now and then. A lot will depend on how well the market responds to the end of the taper and whether that feeds through to the real economy.