The latest OECD forecast for 2016 US GDP growth is 1.4%. That would be the lowest since the recovery began – i.e the lowest since the -2.8% in 2009. It is also lower than the 1.5% forecast for the Eurozone, and lower than the 1.7% forecast for the UK. Yet the market is currently pricing a 70% probability of the FOMC raising its funds rate target by December, while all the talk is about when the UK will cut rates again and whether the ECB will ease again. Of course, current growth is not necessarily the prime determinant of the Fed’s decision. They are forward-looking, and focus on dual targets of inflation and employment, but growth is the major consideration for both these objectives, and while future growth is expected to be better, growth has disappointed all this year so forecasts of future strong growth require a degree of optimism. We have the Q3 GDP data for the US on October 28th. The consensus forecast is still around 2.7%, but the Atlanta Fed GDPNow model is currently showing a forecast of 1.9%. If we were to get another sub-2% growth number in Q3, the probability of the Fed tightening in December would surely dip sharply.
Of course, the reason most are looking for a December rate hike is not because they have done a deep assessment of the economic rationale and put a lot of trust in their forecasts of growth and inflation. It is because they think the Fed have said they will. The three dissents at the September FOMC notably included former arch-dove Eric Rosengren, and many see this as a signal that the Fed is preparing for a December move. But the latest speech from Yellen ought to cast a bit of doubt on this assessment. Yellen didn’t specifically indicate a policy intention, but she did suggest a possible willingness to try to run a faster economy in order to recover some of the lost output seen since the recession. As she put it – “If we assume that hysteresis is in fact present to some degree after deep recessions, the natural next question is to ask whether it might be possible to reverse these adverse supply-side effects by temporarily running a “high-pressure economy,” with robust aggregate demand and a tight labor market.” If she wants to try this, raising rates when growth hasn’t reached 2% in any of the last three quarters, as would be the case if Q3 GDP comes in sub 2%, doesn’t seem to be a sensible tactic. We certainly don’t have “robust aggregate demand” on this reading.
The tightness of the labour market is perhaps the best argument for higher rates. Traditional economics has tended to focus on the labour market as the main driver of inflation, as a tight market drives up wages and costs. However, there are three points to make on this. First, that although the US is no doubt close to full employment, the unemployment rate in the US hasn’t fallen in the last year, at least partly because of the weakness in growth. Second, average weekly earnings growth hasn’t been rising. If anything it’s been falling, with the 3 mth y/y average dipping below 2% in October for the first time since February 2014. Third, Yellen’s latest speech highlights that the labour market hasn’t really been the driver of inflation in recent years. As she notes “the influence of labor market conditions on inflation in recent years seems to be weaker than had been commonly thought prior to the financial crisis.” So although the unemployment rate is quite low by historic standards, it’s not falling and doesn’t appear to be putting upward pressure on wages.
As for inflation, the Fed’s preferred measure – the PCE deflator – is steady at 1% and hasn’t been above 2% since 2012. While oil price fluctuations may move it short-term, it is not currently an issue the Fed has to worry about. If anything, the concern is still to convince the market and the public that inflation is likely to rise from here. Recent years have proved that deflation is a much harder issue to deal with.
So I find it very hard to make a case for higher rates based on the current state of growth, inflation and unemployment, and the latest speech from Yellen suggests to me that she does too. The rate hike last December was based on much stronger growth expectations and some evidence that growth is moving back above trend looks necessary to me to justify another move. Given her recent speech I suspect Yellen feels the same.
Now, there are of course other arguments for raising rates. The side-effects of holding rates very low are generally perceived to be damaging, with savers penalised and asset owners rewarded. Inequality increases as a result. But this is a reason to want rates higher in the longer run, not necessarily now.
It will take a lot to change the market’s mind on the Fed, but it seems to me that the current 70% probability priced in for a (November or) December hike is overly confident. The Q3 GDP data may change this view, but it may require a Fed comment or two to move expectations even if the GDP data do disappoint, given the market’s current tendency to need to be led by the nose. Many on the Fed who want a hike clearly aren’t really basing it on the current behaviour of the economy.