There is an argument for a higher US policy rate

By investment economist Arthur Kamp

The US target rate hike cycle is more gradual than expected

According to the US Federal Open Market Committee (FOMC) participants’ assessments of appropriate monetary policy, published alongside the Fed’s economic projections in December 2014, most members of the FOMC thought the federal funds target rate would be 1% or higher at end 2015 and 2% or higher at end 2016. Indeed, of the 17 participants, six expected the federal funds target rate would be higher than 3% by the end of this year.

These projections were based, in part, on a straightforward narrative: as growth recovers and the unemployment rate falls, upward pressure on wages would lead to higher inflation, which requires the FOMC to raise its policy rate.

US GDP growth is falling short

But, expectations of an imminent lift-off in the federal funds target rate have been dashed on numerous occasions. Since December 2014, the FOMC has increased the target range for the federal funds target rate just once, in December 2015, from 0.00-0.25% to 0.25-0.50%. This is partly because GDP growth has fallen short of expectations. Indeed, real growth of significantly less than 2% is expected for 2016.

Inflation is subdued

Meanwhile, inflation has been well behaved. Although core consumer price inflation increased 2.3% in the year to August 2016, the core PCE deflator’s annual advance has been relatively steady at a shade above 1 ½% this year (+1.57% y-on-y in July 2016).

Labour market is relatively stable

Meanwhile, the US Federal Reserve’s Labour Market Conditions Index (LMC) reflects a softening trend. Still, the level of the LMC index is not overly worrying when compared with its history. Moreover, although the annual advance in non-farm payrolls has slowed significantly since 2014/15 it has been relatively stable at close to 1.7% since May 2016.

In addition, the US unemployment rate is close to historic lows, while aggregate credit extension by US commercial banks has recovered since the Great Financial Crisis slump. Historically, conditions similar to this have been a precursor to the US Federal Reserve hiking its policy rate.  But, the Fed has been holding off, seemingly mindful of the tepid nature of GDP growth (the durability of which is open to question amid weak private business fixed investment spending). Possibly, too the strength of the US$ and fragility of global real economic activity have also convinced members of the US FOMC to tread carefully.

Productivity is complicating matters

But, an important development, which complicates the Fed’s decision-making, is weak productivity – the source of the continued growth disappointment of recent years. The quarterly moving average in US business sector non-farm output (per hour worked) is at its weakest trend level since the late 1970s / early 1980s.

Weak productivity does not only mean real GDP growth will be soft. The flip-side of weak productivity against a backdrop of rising compensation per hour is firm unit labour cost growth. Non-farm business sector unit labour cost increased at an annualised rate of 4.3% in 2Q16, while the annual advance was 2.6%. In the long run, if sustained, I would argue robust unit labour cost growth of this magnitude is not consistent with the Fed’s inflation objective of 2%.

A lot depends on the behaviour of US corporations. US corporate profits with IVA and CCA, as measured by the country’s national accounts (listed plus unlisted companies) fell outright in the year to 2Q16 (-4.3%). The question is: do firms move to contain costs by constraining employment (even though profits margins are still reasonable high relative to history)? If so, that should help to appease the US Fed. However, for now, US non-farm payrolls continue to advance at a good trend. Following the slump to a gain of just 24k in May 2016, payrolls averaged +232k in the three months to August 2016, while the weekly jobless claims data continues to trend around historic lows.

Also, here’s the thing. Poor productivity levels ultimately hold downside risk for real growth and upside risk for inflation.

Inflation currently no great concern

Currently, there appears to be little reason to be overly concerned about inflation (other than some likely upward pressure on headline inflation in 2H16 as the dampening effect of former low oil prices fades). Still, it is worth remembering high inflation is possible in weak growth environments.

In addition, there is the argument that negative real interest rates encourage an inefficient allocation of capital in the long run. Ostensibly the US FOMC would not wish to keep its real policy rate deep in negative territory for too long.

The rate hiking cycle remains intact

There are, therefore, arguments for a higher US policy rate, although a policy rate hike is not expected this week.  Yet, looking further ahead, the arguments above and the FOMC’s apparent desire to “normalise” its policy rate suggest the rate hiking cycle remains intact. On balance, we expect the FOMC to stick with its long-standing communication, which suggests future increases in the federal funds rate are likely to be implemented at a gradual rate, while the federal funds rate is also likely to remain well below its expected long-term level (which the central tendency of the Federal Reserve’s Summary of Economic Projections as at 21 June 2016 projected at 3.0 to 3.3%) for an extended period.

This has been our base case for a long time and it still seems appropriate – given current information.