Up until now every time the Federal Open Market Committee has had a meeting, I have maintained that Janet Yellen, the Chairperson of the Federal Reserve of the United States, will not raise interest rates. The latest meeting of the FOMC is currently on (December 15-16, 2015) and I feel that in all probability Janet Yellen and the FOMC will raise the federal funds rate at the end of this meeting.
The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.
So why do I think that the Yellen led FOMC will raise the interest rate now? Two major economic indicators that the FOMC looks at are unemployment and inflation. Price stability and maximum employment is the dual mandate of the Federal Reserve.
There are various ways in which the bureau of labour standards in the United States measures unemployment. This ranges from U1 to U6. The official rate of unemployment is U3, which is the proportion of the civilian labour force that is unemployed but actively seeking employment.
U6 is the broadest definition of unemployment and includes workers who want to work full-time but are working part-time because there are no full-time jobs available. It also includes “discouraged workers,” or people who have stopped looking for work because the economic conditions the way they are make them believe that no work is available for them.
U6 touched a high of 17.2 percent in October 2009, when U3, which is the official unemployment rate, was at 10 percent. Nevertheless, things have improved since then. In October and November 2015, the U3 rate of unemployment stood at 5% of the civilian labour force. The U6 rate of unemployment stood at 9.8% and 9.9% respectively. This is a good improvement since October 2009, six years earlier.
In fact, the gap between U3 and the U6 rate of unemployment has narrowed down considerably. As John Mauldin writes in a research note titled Crime in the Job Report with respect to the unemployment figures of October 2015: “The gap between the two measures [i.e. U3 and U6] is now the smallest in more than seven years, a sign that slack in the labour market is diminishing. And as the Fed weighs a potential rate hike, what may be more important is the number of people working part-time who would prefer to work full-time – that number posted its biggest two-month decline since 1994. Janet Yellen has referred to this number as often as she has to any other specific number. It is on her radar screen.”
In fact, Janet Yellen seems to be feeling reasonably comfortable about the employment numbers. As she said in a speech dated December 2, 2015: “The unemployment rate, which peaked at 10 percent in October 2009, declined to 5 percent in October of this year…The economy has created about 13 million jobs since the low point for employment in early 2010.”
Another indicator that has improved is the number of people who want to work full time but can’t because there are no jobs going around. As Yellen said: “Another margin of labour market slack not reflected in the unemployment rate consists of individuals who report that they are working part time but would prefer a full-time job and cannot find one–those classified as “part time for economic reasons.” The share of such workers jumped from 3 percent of total employment prior to the Great Recession to around 6-1/2 percent by 2010. Since then, however, the share of these part time workers has fallen considerably and now is less than 4 percent of those employed.”
On the flip side what most economists and analysts don’t like to talk about is the fact that the labour force participation rate in the United States has fallen. In November 2015 it stood at 62.5%, against 62.9% a year earlier. It had stood at 66% in September 2008, when the financial crisis started.
Labour force participation rate is essentially the proportion of population which is economically active. A drop in the rate essentially means that over the years Americans have simply dropped out of the workforce having not been able to find a job. Hence, they are not measured in total number of unemployed people and the unemployment numbers improve to that extent.
This negative data point notwithstanding things are looking up a bit. With the U3 unemployment rate down to 5% and U6 down to less than 10%, companies, “in order to entice additional workers, businesses may have to think about paying more money,” writes Mauldin.
And this means wage inflation or the rate at which wages rise, is likely to go up in the days to come. The wage inflation will push up general inflation as well as buoyed by an increase in salaries people are likely buy more goods and services, push up demand and thus push up prices. At least that is how it should play out theoretically.
As Yellen said in a speech earlier this month: “Less progress has been made on the second leg of our dual mandate–price stability–as inflation continues to run below the FOMC’s longer-run objective of 2 percent. Overall consumer price inflation–as measured by the change in the price index for personal consumption expenditures–was only 1/4 percent over the 12 months ending in October.”
But a major reason for low inflation has been a rapid fall in the price of oil over the last one year. How does the inflation number look minus food and energy prices? As Yellen said: “Because food and energy prices are volatile, it is often helpful to look at inflation excluding those two categories–known as core inflation…But core inflation–which ran at 1-1/4 percent over the 12 months ending in October–is also well below our 2 percent objective, partly reflecting the appreciation of the U.S. dollar. The stronger dollar has pushed down the prices of imported goods, placing temporary downward pressure on core inflation.”
In fact, the fall in the price of oil has also brought down the fuel and energy costs of businesses. This has led to a fall in the prices of non-energy items as well. “Taking account of these effects, which may be holding down core inflation by around 1/4 to 1/2 percentage point, it appears that the underlying rate of inflation in the United States has been running in the vicinity of 1-1/2 to 1-3/4 percent,” said Yellen.
In fact, a careful reading of the speech that Yellen made on December 2, clearly tells us that she was setting the ground for raising the federal funds rate when the FOMC met later in the month.
On December 3, 2015, Yellen made a testimony to the Joint Economic Committee of the US Congress. In this testimony she exactly repeated something that she had said a day earlier in the speech. As she said: “That initial rate increase would reflect the Committee’s judgment, based on a range of indicators, that the economy would continue to grow at a pace sufficient to generate further labour market improvement and a return of inflation to 2 percent, even after the reduction in policy accommodation. As I have already noted, I currently judge that U.S. economic growth is likely to be sufficient over the next year or two to result in further improvement in the labour market. Ongoing gains in the labour market, coupled with my judgment that longer-term inflation expectations remain reasonably well anchored, serve to bolster my confidence in a return of inflation to 2 percent as the disinflationary effects of declines in energy and import prices wane.”
This is the closest that a Federal Reserve Chairperson or for that matter any central governor, can come to saying that he or she is ready to raise interest rates. My bet is that the Yellen led FOMC will raise rates at the end of the meeting which is currently on.
Nevertheless, this increase in the federal funds rate will be sugar coated and Yellen is likely to make it very clear that the rate will be raised at a very slow pace. This is primarily because the American economy is still not out of the woods.
The economic recovery remains fragile and heavily dependent on low interest rates. Net exports (exports minus imports) remain weak due to a stronger dollar. Yellen feels that this has subtracted nearly half a percentage point from growth this year.
In this environment economic growth in the United States will be heavily dependent on consumer spending, which in turn will depend on how low interest rates continue to remain. As Yellen said in her recent speech: “Household spending growth has been particularly solid in 2015, with purchases of new motor vehicles especially strong….Increases in home values and stock market prices in recent years, along with reductions in debt, have pushed up the net worth of households, which also supports consumer spending. Finally, interest rates for borrowers remain low, due in part to the FOMC’s accommodative monetary policy, and these low rates appear to have been especially relevant for consumers considering the purchase of durable good.”
This again is a clear indication of the fact that the federal funds rate in particular and interest rates in general will continue to remain low in the years to come.
As Yellen had said in a speech she made in March earlier this year: “However, if conditions do evolve in the manner that most of my FOMC colleagues and I anticipate, I would expect the level of the federal funds rate to be normalized only gradually, reflecting the gradual diminution of headwinds from the financial crisis.”
I expect her to make a statement along similar lines either as a part of the FOMC statement or in the press conference that follows or both.
(The column originally appeared on The Daily Reckoning on December 16, 2015)