USA: an impression of capacity under-utilization…

Those who were hoping for a shift in tone from the Federal Reserve regarding an imminent rate hike, encouraged by increasing signs of a recovery in the US, will be disappointed. The Fed has reiterated its concerns over the dynamics of the economy.

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Two main factors have to be taken into consideration. Firstly, the employment market, which although improving, remains listless. At 6.1%, the unemployment rate effectively remains above the level of full employment, which is considered to be between 5.2% and 5.5%. Although conditions in the jobs market have continued to improve, the unemployment rate has fallen only marginally. Furthermore, a series of indicators, such as the participation rate, have suggested a significant under-utilization of capacities in the employment market. The disappointing number of new jobs created in August vindicated the Fed’s cautious stance, particularly as other indicators have shown no real signs of a firm recovery.

The recovery in the property market also remains “sluggish”. Furthermore, consumer prices declined in August for the first time in eighteen months, whereas the core inflation rate was zero, a level not seen since October 2010. Meanwhile, wages are not increasing either. The jobs market and inflation are inexorably linked. Under normal conditions, this type of improvement in employment data would boost household income, accelerate consumer spending and help reflate the economy. However, the current improvement in employment (inverted right-hand scale) in a context of rising structural and long-term unemployment, limits any increase in household income (left-hand scale). This type of divergence, which has not previously occurred for a long time, fails to produce a reflation of the economy, which the Fed is trying to promote by any means. The slow rate of wage growth appears to reflect the listlessness of the jobs market.

Therefore, as the Fed has committed to maintaining an ultra-accommodating monetary policy “for a considerable period” once the asset-repurchase program has been completed, despite the fact that the central bank’s forecasts now demonstrate that interest rates, when they finally rise, may well be hiked more steeply than it had initially predicted. The markets immediately started pricing-in this inflexion. The rally in 10-year bond yields, which had been impacted by the prospect of the termination of the quantitative easing program in October, came to a halt.

Furthermore, the Fed also revised its growth forecasts downwards once again. Growth of between 2% and 2.2% is now expected for 2014 (compared with 2.1% and 2.3% forecast in June). For 2015, the Fed is now predicting growth of between 2.6% and 3.0%, which is sharply down on the 3.0% - 3.2% previously expected. These downgrades could also impact the currency and commodities. The dollar, which has rallied steadily since early summer, could now lose momentum. The generally negative correlation linking the dollar to oil may also curb the fall in the price of the barrel.

The Fed has announced that its quantitative easing measures would be discontinued in October, but it has clearly not altered its stance concerning a forthcoming hike in interest rates. The US central bank has stuck doggedly to its position, with interest rates set to remain close to zero for “a considerable period of time” after the close of the treasury-bill and mortgage securities repurchase program, which it has implemented to support the economy.

The markets have yet to be fully convinced. Janet Yellen has to win them over, however, if she wishes to preserve credibility in her efforts to rekindle a degree of inflation, and more particularly to curtail an impression of capacity under-utilization in the jobs market. As such, volatility among long-term rates and the dollar may surge as a reflection of divergent perceptions between the Fed and investors.

Despite the cautious approach adopted by the Fed, certain committee members have expressed that improvements in the economic climate observed in recent months “and continued signs of financial market excess” will probably justify tapering the accommodating monetary policy more rapidly than anticipated.

Franck Nicolas September 2014

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