The strong month has come against a backdrop of ongoing crisis in Ukraine, potential crisis in Greece, and increasing pressure on the Federal Reserve to raise rates here at home. Fed Chair Yellen presented a fairly upbeat outlook for the US economy and labor market as she addressed the issue of raising rates in her testimony before Congress. While she was careful not to commit to specific thresholds, given the nature of the beast it seems that the upcoming February employment report will take on some added significance.
Based on Chair Yellen’s testimony, it appears the Fed does not seem too worried about deflation. She noted the consistently improving labor market, increasing domestic spending, and increasing production since last July’s monetary policy update. She further attributed the recent decline in inflation to the drop in energy prices, which she said was due more to oversupply than decreased demand, and stated that, “the fall in inflation compensation mainly reflects factors other than a reduction in long-term inflation expectations.” Perhaps the most important part of her prepared testimony was when she addressed the Fed’s forward guidance. She said, “It is important to emphasize that a modification of the forward guidance should not be read as indicating that the Committee will necessarily increase the target range in a couple of meetings. Instead the modification should be understood as reflecting the Committee’s judgment that conditions have improved to the point where it will soon be the case that a change in the target range could be warranted at any meeting [italics supplied].” This suggests that a June rate hike is still possible, particularly if the February employment numbers continue the supportive trend.
We are skeptical of the need for a rate hike as soon as June regardless of February’s employment data for several reasons: so far there is no evidence of upward pressure on wages, regardless of the reason the already minor rate of inflation has decreased, and the neither the Fed nor anyone else truly knows what unemployment rate corresponds to “full employment.” Further, the levels of long-term unemployed are still quite high and this contributes to the lack of upward pressure on wages as more of these folks re-enter the work force. Without upward pressure on wages inflation is likely to remain quite subdued, thus raising rates too soon could have significant negative consequences on our economic recovery. Remember it is much easier to bring inflation under control than it is to reign in deflation.
Next week we will watching the employment-related reports of Wednesday, Thursday, and Friday, as well as the Personal Income and Outlays report and the ISM Manufacturing Index on Monday.