Fed doubles down on its new policy framework - Capital Economics
US Economics

Fed doubles down on its new policy framework

US Economics Weekly
Written by Michael Pearce
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Fed Chair Jerome Powell’s testimony to Congress – together with similarly-dovish speeches from key Board members this week – underlined the Fed’s new commitment to the full employment side of its mandate. That may not have convinced investors, but we think the new focus all but kills any prospect of interest rate hikes in the coming years – regardless of what happens to inflation.

Fed Chair Jerome Powell’s testimony to Congress – together with similarly-dovish speeches from key Board members this week – underlined the Fed’s new commitment to the full employment side of its mandate. That may not have convinced investors, but we think the new focus all but kills any prospect of interest rate hikes in the coming years – regardless of what happens to inflation.

Doves rule the roost at the Fed

While we’ve gotten used to hearing dovish comments from Fed officials in recent months, it was still notable that Powell used his semi-annual testimony to Congress this week to double down on the Fed’s new commitment to achieving a “broad and inclusive” labour market recovery. Those comments were even more notable given they come against a backdrop of a sharp rebound in retail sales in January, as consumers quickly spent stimulus cheques on discretionary goods, and while an additional $1.9trn stimulus appears close to passing the House.

In response to questioning from Sen. Kyrsten Sinema, Powell argued that simply getting the headline unemployment rate down to Fed officials’ longer-run estimate of 4% would not constitute full employment, and highlighted a range of other metrics, including the broader employment-to-population ratio, as benchmarks with which to measure the shortfalls from full employment. Those broader measures imply there is far more spare capacity in the labour market than the headline unemployment rate of 6.3% suggests. (See Chart 1.) As we pointed out in a previous Update, however, some of the decline in the employment/population ratio may be structural.

On the inflation side of the mandate, Powell suggested that, aside from base effects which will push the annual rate of inflation up sharply over the coming months, he is not expecting a rise in price pressures this year to be “particularly large or persistent”. That is, the Fed would interpret any surge in price pressures this year linked to resurgent demand as the economy reopens as transitory.

Chart 1: Unemployment & Employment to Pop. Rate (%)

Source: Refinitiv

We wouldn’t be so sure that any burst of inflation ends up being a one-off, as the Fed seems to be assuming. After all, market-based measures of inflation compensation have rebounded markedly over recent months, while survey-based measures of expectations have trended higher since the pandemic began. Meanwhile, wage growth has barely fallen, despite the huge hit to employment. In that environment, a temporary rise in inflation has a greater risk of becoming entrenched. As we argued in a Focus earlier this week, the enormous $1.9trn fiscal package only adds to the upside risks to inflation this year.

Minimum wage hike off the table, for now

A series of sharp minimum wage hikes won’t be adding to the upward pressure on wages and prices, at least for now. The ruling from the Senate Parliamentarian this week that minimum wage hikes fall foul of the Byrd Rule means Democrats will be unable to pass it using the budget reconciliation process through which they will pass fiscal stimulus.

The week ahead

We expect the February employment report, due out on Friday, to show a stronger 500,000 gain in non-farm payrolls, as the recovery in the labour market gets back on track, while the February ISM surveys are likely to have remained strong. Aside from the economic data, the House looks set to approve the $1.9trn fiscal package over the weekend, with debate set to shift next week to the Senate.


Data Previews

ISM Manufacturing Index (Feb.) 10.00 Mon. 1st Mar.

Forecasts

Previous

Median

Capital Economics

Headline index

58.7

58.9

59.0

Manufacturing holding up well

Our model suggests that the ISM manufacturing index remained elevated in February, consistent with manufacturing activity rising at close to a 10% annualised pace.

The regional survey evidence in February continued to strengthen while the national Markit flash manufacturing PMI only edged down to a still-hot 58.5, from 59.2. We know that goods demand bounced back strongly in January, which should have put even more pressure on inventories.

Shortages of semiconductors caused stoppages in auto production in January and reports suggest those problems intensified in February. That won’t necessarily weigh on the headline ISM index, however, because lengthening supplier delivery times count as a positive contribution to the aggregate index.

Our model, based on inputs from the timelier survey evidence as well as global indicators such as Korea’s trade data, suggests that the ISM manufacturing index remained close to the 59.0 mark in February. (See Chart 2.)

Chart 2: ISM Manufacturing & CE Model

Sources: Refinitiv, Capital Economics

ISM Services Index (Feb.) 10.00 Wed. 3rd Mar.

Forecasts

Previous

Median

Capital Economics

Headline index

58.7

58.7

60.0

Loosening restrictions & stimulus will provide renewed boost

The easing of containment measures and the boost from the $900bn stimulus passed late last year means we expect the ISM services index to remain at a very high level. Based on our model, we expect the index to rise a touch further to 60.0 in February, from 58.7.

Most of the key components of the Markit services PMI edged higher in February, as did the key regional services surveys. Reopening of indoor dining in heavily-populated coastal states should provide a pick me up to employment, while the boost from additional fiscal support will also have supported demand in other sectors.

Together with the strong manufacturing reading we expect, that would leave the composite ISM index at a near two-year high and consistent with GDP growth accelerating in the first quarter from the 4.0% annualised pace seen in the fourth. (See Chart 3.)

Chart 3: Weighted ISM Index & GDP Growth

Source: Refinitiv

Employment Report (Feb.) 08.30 Fri. 5th Mar.

Forecasts

Previous

Median

Capital Economics

Change in Non-Farm Payrolls

+49,000

+148,000

+500,000

Unemployment Rate

6.3%

6.4%

6.3%

Average Hourly Earnings

+0.2%(+5.4%)

+0.2%(+5.3%)

-0.2%(+4.9%)

Average Weekly Hours Worked

35.0

34.9

34.7

Recovery back on track

With virus cases falling and containment measures being eased, we expect the partial reopening of the leisure and hospitality sector to translate into a 500,000 increase in non-farm payrolls in February.

The muted 49,000 rebound in payrolls in January was largely because the employment survey was conducted in the first half of the month, with the subsequently-reported surge in retail sales demonstrating that the slower virus spread and renewed fiscal stimulus made a big difference over the month as a whole. The 6.9% jump in food services sales last month was far stronger than the fall in leisure & hospitality sector payrolls implied, and also fits with the continued recovery in diner numbers reported by OpenTable. (See Chart 4.) That implies a rebound in food & drink services payrolls of close to 400,000, with employment across the rest of the leisure sector also likely to have picked up.

The still elevated level of jobless claims and soft survey evidence suggest that employment growth outside the leisure sector remained subdued last month, with the severe winter weather also posing a downside risk. Even so, we still expect overall employment to have risen by 500,000. We suspect the unemployment rate held steady at 6.3%, but it should continue to trend lower this year.

Chart 4: Restaurant Diners & Payrolls

Sources: Refinitiv, OpenTable

International Trade (Jan.) 08.30 Fri. 5th Mar.

Forecasts

Previous

Median

Capital Economics

International trade balance

-$66.6bn

-$67.5bn

-$67.5bn

Trade deficit stabilising

We calculate that the trade deficit edged up in January, but the bigger picture is that the recovery in exports is now catching up with imports.

The advance report showed the goods trade deficit widened slightly to $83.7bn in January, from $83.2bn as, in dollar terms, the 1.1% m/m rise in imports was larger than the 1.4% m/m increase in exports. The former continues to be buoyed by a surge in demand for consumer goods, with imports in that category now up 18.8% y/y. A rise in the price of oil also boosted the value of petroleum trade in both directions. Encouragingly, exports of capital goods increased by 3.9% m/m in January. The survey evidence suggests the rebound in exports has further to run. (See Chart 5.)

We expect the overall trade deficit rose to $67.5bn in January, from $66.6bn. But that would still be consistent with net trade being close to neutral for GDP growth in the first quarter, after being a big drag on growth in the second half of 2020.

Chart 5: Real Exports & ISM Export Orders

Source: Refinitiv


Economic Diary & Forecasts

Upcoming Events and Data Releases

Date

Release/Indicator/Event

Time EST (GMT-5)

Previous*

Median*

CE Forecasts*

Mon 1st

ISM Manufacturing Index (Feb)

10.00

58.7

58.9

59.0

Construction Spending (Jan)

10.00

+1.0%

+0.7%

Tue 2nd

No Significant Data Released

Wed 3rd

Change in ADP Employment (Feb)

08.15

+174,000

+168,000

ISM Services Index (Feb)

10.00

58.7

58.7

60.0

Fed’s Beige Book

14.00

Thu 4th

Non-farm Productivity (Q4, Final)

08.30

-4.8%

-4.6%

Unit Labour Costs (Q4, Final)

08.30

+6.8%

+6.6%

Initial Jobless Claims (w/e 27th Feb)

08.30

730,000

Factory Orders (Jan)

10.00

+1.1%

+1.0%

+2.3%

Fri 5th

Change in Non-Farm Payrolls (Feb)

08.30

+49,000

+148,000

+500,000

Unemployment Rate (Feb)

08.30

6.3%

6.4%

6.3%

Average Hourly Earnings (Feb)

08.30

+0.2%(+5.4%)

+0.2%

-0.2%(+4.9%)

Average Weekly Hours Worked (Feb)

08.30

35.0

34.9

34.7

International Trade (Jan)

08.30

-$66.6bn

-$67.5bn

-$67.5bn

Change in Consumer Credit (Jan)

10.00

+$9.73bn

Selected future data releases and events

10th Mar

Consumer Prices (Feb)

08.30

12th Mar

Producer Prices (Feb)

08.30

Uni. of Mich. Consumer Confidence (Mar)

10.00

17th Mar

Fed Policy Announcement

14.00

*m/m(y/y) unless otherwise stated

Sources: Bloomberg, Capital Economics

Main Economic & Market Forecasts

%q/q ann. (%y/y) unless stated

Q4 2020

Q1 2021

Q2 2021

Q3 2021

Q4 2021

Q1 2022

2020

2021

2022

GDP

+4.0

+7.0

+10.0

+4.3

+4.0

+3.5

(-3.5)

(+6.5)

(+4.0)

CPI Inflation

(+1.2)

(+1.6)

(+3.1)

(+2.5)

(+2.4)

(+2.4)

(+1.3)

(+2.4)

(+2.3)

Core CPI Inflation

(+1.6)

(+1.7)

(+2.5)

(+2.1)

(+2.2)

(+2.2)

(+1.7)

(+2.1)

(+2.2)

Unemp. Rate (%), Period Ave.

6.8

6.4

5.1

4.8

4.5

4.4

8.1

5.2

4.4

Fed Funds Rate, End Period (%)

0.00-0.25

0.00-0.25

0.00-0.25

0.00-0.25

0.00-0.25

0.00-0.25

0.00-0.25

0.00-0.25

0.00-0.25

10y Treas. Yld., End Period (%)

0.93

1.15

1.30

1.40

1.50

1.55

0.93

1.50

1.75

S&P 500, End Period

3756

3950

4000

4100

4200

4300

3756

4200

4500

$/€, End Period

1.22

1.22

1.23

1.24

1.25

1.25

1.22

1.25

1.25

¥/$, End Period

103

103

102

101

100

100

103

100

100

Sources: Refinitiv, Capital Economics


Michael Pearce, Senior US Economist, +1 646 583 3163, michael.pearce@capitaleconomics.com