The Fed: data-dependent or market-scared?

Tom Traill - 6 February 2019

The most contrarian trade in the world right now is that the Fed hikes in 2019, according to Bank of America. The Fed's dovish statement and press conference last week marked a decisive shift from the December meeting and strongly suggested a pause in the tightening cycle. This has revived suspicions, even accusations, that that the Fed is seeking to protect the markets, rather than the real economy. 

The Federal Open Market Committee was never likely to raise the target funds rate at the January meeting, but the markets have readily interpreted the perceived hesitation to mean that there will be no rate rises in 2019 and maybe even rate cuts in 2020. Meanwhile, the famous dot plot has not ruled out at least one rate increase this year. The Fed might be moving in the dovish direction, but it is desperately trying to keep the door open for a possible rate increase. Chairman Jay Powell keeps insisting that the Fed is data-dependent, but what data? What are the rogue data points that could persuade the FOMC to resume tightening?

In his press conference transcript, Powell refers to muted inflation readings in the context of the recent drop in oil prices and notes that “financial market measures of inflation compensation have moved lower.” Is he inferring that a drop in inflation breakevens is a justification for keeping rates on hold? 

Significantly, the chairman faced no questions about the strength of the labour market and acceleration of wages (figure 1). He studiously avoided any mention of the tension that an overheated labour market might present for the short-term inflation outlook.  The jobs report on Friday will not have been easy reading for Mr Powell – another large, above consensus jobs gain, the 100th gain in a row and wage inflation of 3.2 per cent and an upgrade of December's wage growth to 3.3 per cent. 

Unless there are some teething issues from the fall out of the government shutdown and its potential sequel, it is likely that wage inflation will jump again next month. February 2018 saw a relatively low, 0.1 per cent, month-on-month gain, setting a weak comparator for the early-March release (figure 2). December's employment cost index growth for the final quarter of 2018 rose to 2.9 per cent, the highest post crisis.

Powell’s disregard for the inflationary messages pouring out of the labour market could return to bite him. Core CPI inflation remains around 2 per cent and the New York Fed’s Underlying Inflation Gauge is still coming in at around 3 per cent (figure 3). Headline inflation measures tell a soothing story, but underlying inflationary pressures are strengthening. If financial conditions are normalising after a brutal fourth quarter, at what point will the Fed need to raise interest rates to express concern over inflation, even if that imperils financial asset prices? Is the Fed genuinely data-dependent or simply market-scared?  

Figure 1

Data source: FRED

Figure 2

Data source: FRED

Figure 3

Data sources: FRED and Federal Reserve Bank of New York

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