The Dots

As was widely anticipated, Federal Reserve policymakers reduced the monthly pace of asset purchases by another $10 billion and kept the “considerable time” language. Fed policymakers revised slightly their forecasts of growth, unemployment, and inflation. However, the really interesting item in the Fed’s Summary of Economic Projections was the dot plot, the projections of the appropriate year-end level of the federal funds rate for each of the next few years. There is a huge range of uncertainty among Fed officials.

In announcing its plans to normalize policy, the Federal Open Market Committee indicated that it will announce a range for the federal funds rate. The dot plots show the middle point of each Fed official’s projection of the appropriate year-end range. The five Fed governors and 12 district bank presidents differ widely in their expectations for the federal funds rate at the end of 2015 (and implicitly, in their expectations of when the Fed will begin raising short-term rates). Projections of the federal funds rate at the end of 2016 are even more widely dispersed.

The 2015 projections suggest that there is not clear consensus among Fed officials regarding when the first rate hike will come. Implicitly, most appear to be almost evenly spread between March and September next year. In the Fed’s next update of these projections (December 17), we should see the 2015 dots coalesce around a specific level, signifying a developing consensus for when the first rate hike will occur.

Why such a large range in the federal funds rate projections? Fed officials differ in their expectations for growth and inflation, but mostly in their perceptions of the amount of slack in the economy, especially in the job market. The unemployment rate has fallen significantly over the last few years, but the figure has been distorted by a drop in labor force participation. The baby-boomers began to reach retirement age just as the Great Recession got underway, making it difficult to isolate the demographic impact. Moreover, the unemployment rate does not reflect underemployment, the number of individuals who are involuntarily working part time but would prefer full-time employment, and those who are not searching for a job but would if the labor market were stronger.

There are many labor market indicators. Some suggest stronger conditions than others. As Fed Chair Yellen noted in her Jackson Hole speech, the Kansas City Fed’s Labor Market Conditions Index, a composite of 24 job market gauges, provides a convenient summary. The trend in the LMCI through August is consistent with the view that the slack in the labor market is being taken up gradually, but that we still have a long way to go.

A weak trend in inflation-adjusted earnings is another sign of slack in the job market. Real average hourly earnings rose just 0.4% over the 12 months ending in August. That’s not a lot of firepower for consumer spending growth. Thanks to job growth, you can still get growth in aggregate income, and in turn aggregate spending, but the lack of wage growth is a limiting factor for consumer spending growth (which accounts for 70% of Gross Domestic Product). Wage growth should pick up as the labor market tightens, but recent reports suggest little upward pressure on wages for the near term.

Fed Chair Yellen emphasized that rates could be raised “sooner and more rapidly” if the economy proves to be stronger than expected. Conversely, if economic performance disappoints, “increases in the federal funds rate are likely to take place later and to be more gradual.” While there is a wide range in the projections of Fed officials, there is a high degree of uncertainty in the individual forecasts themselves. The decision to begin raising rates will be driven by the economic outlook, estimates of the amount of slack in the job markets, and assessments of how rapidly slack is being taken up. The recent economic data suggest that the Fed will be in no hurry to tighten.

© Raymond James

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