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June 3, 2005

Fed Watch: Growing Uncertainty About the Path of Monetary Policy

Tim Duy's latest Fed Watch: Growing Uncertainty About the Path of Monetary Policy Or should I say growing certainty? In the wake of this morning’s tepid employment report, Wednesday’s disappointing read on manufacturing, and Dallas Fed President Richard Fisher’s comments, market participants are looking for the Fed to pause after this month’s meeting. From the Wall Street Journal website:
Federal-funds futures are pricing in only a 43% chance the Fed will raise rates by a quarter-percentage point at the Aug. 10 Federal Open Market Committee meeting. That's down from a 75% chance before news that employers added just 78,000 jobs in May, the slowest pace of payroll growth in nearly two years and considerably lower than forecasts for 185,000 new jobs.
The markets may have decided the path of monetary policy, but I doubt that Greenspan & Co. have done the same. Either the Fed will move to the markets or vice versa. Either way, it looks like we could be in for a wild ride this month as this disconnect is resolved. The economy added 78,000 jobs in May, well below expectations and the previous month’s gain of 274,000 jobs. Of course, on average, the economy added over 150,000 jobs a month over the two month period – and that figure is likely to be more relevant for policymakers, especially given how volatile these data have been. The unemployment rate fell to 5.1% - and while this is discounted by the markets, I doubt it will be on Constitution Ave. Much of the rest of the report was ho-hum; no devastating weakness, but nothing to cheer about either. One, however, could look at the drop in the unemployment rate, coupled with the rise in Q1 labor costs reported yesterday, and conclude that the labor market is tighter than many analysts believe. Here is the chart of the year-over-year change in unit labor costs:
Note: Click on Image for Larger Version
Some have discounted the run-up in labor costs as an end of year, one time occurrence. The question, of course, is if policymakers will view the data in the same vein. I don’t think they will. Rather than focus on a single month's slowdown in hiring, I believe policymakers will look at the whole of the data and conclude that the pace of hiring continues its erratic behavior, while the falling unemployment rate and rising unit labor costs suggest the possibility of incipient inflation pressures – implying Fed officials believe they will have more work to do after this month’s meeting. This view may change as the month wears on, of course. This is a way of saying that three more weeks of these kinds of data may nudge the Fed closer to the markets. Note that this is the last employment report before the next FOMC meeting. There is another possible path: The market comes to the less bearish, and more inflation fearing view that I suspect is the consensus among FOMC members. One path to that outcome is for the incoming data to turn more positive on the growth side or negative from the inflation side. If the data don’t lead the markets in that direction, and the Fed remains in the “measured increases” mode, then Fedspeak will have to shift expectations back to the pre-Fisher comments. Otherwise, traders will be in for a surprise come June 30, an outcome that I doubt would be viewed favorably by an increasingly transparent Fed. Be on the lookout for well-sourced articles in the Wall Street Journal. One more thought – the markets appear to be pricing in a sizable slowdown in the second half of the year. Many have repeated such bearish sentiments; see, for example, Brad Setser’s thoughts on the unbalanced US economy. For a contrarian view, note that copper has broken out to the upside. This suggests to me that reports of economic weakness may be premature. Update 6/3/05 by Mark Thoma: Here are remarks made Friday by Federal Reserve Governor Edward Gramlich as reported by Reuters. Note the emphasis on price stability and the refusal to support Fisher's comments when given the opportunity:
Gramlich says doesn't know where Fed is on rates … Dallas Fed President Richard Fisher likened the Fed's rate-hike campaign to a baseball game and said the central bank was in the "eighth inning." Although Fisher also said the Fed might need to go into extra innings, traders took his comments as a sign that an end to the rate rises may be near. When asked by reporters about Fisher's comments, Gramlich said: "I don't know what inning we're in, period." The Fed governor, who is set to step down at the end of August, said he felt the United States had won price stability and would work to keep it...

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