Solid US job report in June

The #US June #employment report shows that the drop seen in May (72 000) was temporary. The June figure was 224 000 and 191 000 for the private sector. The average for both measure is close to figures observed in 2016 and 2017. No necessity for the Fed to act rapidly. In 2017, the Fed was tightening smoothly.

On the wage side, the deceleration is rapid at 3.14% on a year (3.4% in Feb.). Graph shows that the Fed rate can manage a plateau as long as wages do not drop rapidly. This would be caused by a strong growth slowdown. It’s not the case yet. Therefore, nothing is expected on the Fed’s side in July.

Can we expect lower Fed’s rate in July ?

The possibility of a 50 basis point interest rate cut by the US Federal Reserve is on everyone’s lips. The dots chart published at the end of the June 19 meeting indicated that rates would remain at the current level in 2019, but it showed that 7 members suggested a 50 bp decrease in 2019 (stability is calculated on the median of the results).
That was all it took for observers to switch to a similarly sharp decline at the July 30-31 meeting. The explanations given are those of Donald Trump’s pressure on the central bank either through threats relayed on Twitter or by the members appointed by Trump to the FOMC.

Such an interpretation raises several questions
The first is that at the Fed, the president always has the last word. Jerome Powell’s recent comments do not give this sense of urgency about lowering rates. This implies that the July rate cut, if it were to take place, would be more than a palace revolution since its president would be outvoted.

The second point is that the macroeconomic data also do not reflect the urgency of a change in the central bank’s strategy.
To gauge the economic situation I used the CFNAI index calculated by the Chicago Fed. It includes 85 indicators of the federal economy (from industrial production to retail sales, employment and orders for durable goods). The calculated indicator is centered on 0, and a value below -0.7 (on the index on average over 3 months as shown in the graph) suggests a risk of recession.

Since 1985 (the beginning of the great moderation), I have then measured the changes in the pace of the Fed’s monetary policy. The first graph shows the fed fund rate and the points used to mark the shift towards an accommodative monetary policy.

The second graph shows the dates of monetary policy changes and the CFNAI index.
Since 1985, monetary policy changes have taken place when the CFNAI index is close to -0.7, i.e. when the risk of recession becomes clearer. The only exception is 2007 when the issue of liquidity on many financial structures was raised. This is a special case.
The current level of the index is not consistent with a decline in Fed rates unless we imagine a deep break in all US indicators for June and July. This is not our scenario.

This means that, in the absence of economic or financial justification, a reduction in the Fed’s rates and a defeat of its President would first reflect a collapse in the credibility of the US central bank due to its loss of independence. As the world’s most powerful financial institution, it is likely to cause significant turmoil in financial markets. Should we take this kind of risk? I don’t think so.

The Fed and the Global Environment

The change of the US monetary policy trend has been radical since the end of January.
At its January 29/30 meeting, the Fed said it was no longer committing to one or more rate hikes, which was confirmed in March when the “dots” chart was published, and it was going to stop the downsizing of its balance sheet, which it confirmed at its March meeting, indicating a balance sheet target of 17% of GDP in the autumn.
The key elements explaining this radical change lie in the international environment. The Fed sends the signal that because of the uncertain global environment, it wants to remain agile by no longer committing on future movements.It even gives the feeling of wanting to limit its “forward guidance” in order to have more leeway in its monetary policy management.

This role of the international environment may be a source of surprise as the economy is self-centered. Its opening rate is 14% in 2018 against 19% in the Euro zone.
A research by Laurent Ferrara and Charles-Emmanuel Teuf at the Banque de France, quoted by Fed’s Richard Clarida in a recent BdF colloquium, suggests that the international environment is a key factor in the reasoning behind FOMC’s decisions
.
The authors create an index containing terms related to the global economy, and integrate it into a Taylor formula. The addition of this indicator in the Taylor Formula , that links interest rate to economic activity and inflation, is significant. Greater attention to these external factors is driving the Fed to more accommodating behavior.
We can therefore better understand the change in tone of the US central bank since the beginning of the year. The international environment has deteriorated rapidly (see graph below) and the Fed is taking into account even if its economy remains robust.
See the initial post of Laurent Ferrara and Charles-Emmanuel Teuf on the Banque de France blog
The graph below traces the pace of their index from 1993 to 2017

Source: Ferrara – Teuf – Banque de France

The following graph shows a Global Economic Policy Uncertainty Index. It suggests and validates the wait-and-see attitude of the Fed in 2016, but emphasizes the opportunity given to it in 2018 to tighten the tone with lower tensions as measured by the index. The year 2019 actually suggests more wait-and-see.

Reversal of the US labor market ?

The labor market indicator in the Conference Board household survey changed trend in March. It is always easy to find a job but the indicator is now on the downside.
Given the strong link with JOLTS labor market indicator, one may wonder about a possible reversal of the US labor market.
This is a signal that seems relevant to me (see here for longer data and more in-depth analysis).

Can a China / USA Agreement be credible?

Financial markets strongly value the possibility of a trade agreement between the United States and China. Such a situation would make it possible to reduce the constraints on global trade and to order them according to the framework defined by the agreement. Nothing would then stand in the way of the return of larger trade flows likely to bring global growth once again.

This idea is attractive because it would leave the area of concern that marks the global economy since last fall and for which we do not spontaneously see a way out.

Yet this possibility of an agreement seems to me to be totally illusory. Tensions between the US and China mainly reflect a problem of technological leadership. Which of these two countries will set the standard for developments like 5G or artificial intelligence or other technologies. Both countries are in fierce competition. I can’t imagine an agreement in which one of the two countries would agree to be subject to the developments of the other. Tensions between the two countries will remain strong even if minor agreements could be signed.

This will generate tension and volatility in the overall dynamics.

The Fed wants to remain agile

The end of the reduction of the Fed’s balance sheet is what we have to keep in mind after the publication of the minutes of the last FOMC meeting. It will take place during the second half of this year.

The US Central Bank does not want to be too constrained in the management of its monetary policy. The pace that was taken and the level targeted until then could add to the difficulty of the good calibrage of the monetary policy.

The Fed clearly does not want to be constrained in its choices because the global environment which is now more uncertain.

The way Yellen initiated the downsizing movement of the balance sheet was possibly compatible with a stable and predictable international environment. The arrival of Trump has created noise and spillover effects because of its policies. Now the Fed must take into account these noises and the risk of contagion which are attached to them.

The Fed does not yield to Trump by not raising rates, but it does not raise them in order to be able to intervene quickly to contain the negative effects of the policy pursued at the White House. She wants to be agile to limit risks. It’s well thought out.