FOMC: Steady Helm Despite Some Choppy Waters

In the face of “nearly balanced risks,” the helm at the FOMC keeps a steady course waiting for new weather signals. Future indications from the labor market, inflation and global growth will provide the signals.

Nearly Balanced Risks: On the Plus Side

Economic activity picked up in the second half of 2014 and labor market conditions continue to improve. Total nonfarm payroll employment expanded faster than generally expected and the unemployment rate fell more quickly than expected (top graph). Job openings have also improved, suggesting further gains ahead. Our outlook is for real economic activity to continue to improve at a 2.5 percent-plus pace for the first half of 2015 and thereby lead to further improvements in the labor market. Our mid-2015 unemployment rate forecast is for 5.4 percent, which is in line with many estimates of full employment. Given these gains in jobs and aggregate wages & salaries, along with home prices and consumer confidence, the consumer is on the upswing as the economy starts 2015. Moreover, government spending is now adding to growth in the economy.

But What About Inflation? Are We Watching the Core?

The key FOMC phrase is “inflation declined further below the Committee’s longer-run objective.” Measures of inflation, such as the PCE deflator, illustrated in the middle graph, continue to run below the 2 percent target. Significantly, the recent weakness in oil prices will lower the overall PCE deflator initially, but will also exert some downward pressure on the core over time. To what extent should the markets and the Fed weigh the overall versus the core deflator? In addition, how much of the decline in oil prices specifically is considered a more permanent change?

Lest We Forget: The Global Outlook? The Dollar?

While the FOMC did not specifically note global economic conditions as a risk, it did by de facto when adding “international developments” onto its list of information to take account of when raising rates. Economic weakness in the Eurozone, accompanied by uncertainty surrounding the Greek election, indicates continued downside risk for the international outlook. The sharp drop in oil prices prompted a cut in rates by the Bank of Canada. Trade and capital flow concerns prompted action by the Swiss National Bank and the Monetary Authority of Singapore. Trade concerns are reinforced by the increase in the dollar’s value, although today’s statement made no note of the dollar’s recent strengthening. This rise reduces the competitiveness of U.S. exports but also increases the debt burden for foreign borrowers who have borrowed in dollars.

Net? Fed Moves in June

Our outlook remains for a Fed move in the funds rate in June. However, at the March FOMC meeting, new targets for the funds are likely to be lowered for year-end 2015 as well as for 2016. We expect the move to a flatter yield curve to persist in 2015. We will watch inflation carefully, though, as that remains the primary risk to a later liftoff.