The Fed, The Yen and the Pound

25 May 2016

On 18 May, the US Federal Reserve released its minutes from the 27 April meeting1. It’s worth noting a few of the key points the Federal Open Market committee had discussed at meeting. In particular, some key points which might indicate less certainty of a June policy action than suddenly expected.

The Fed has two mandates of equal importance: full employment and price stability. On these two accounts the Fed noted that “...The information reviewed for the April 26-27 FOMC meeting indicated that labor market conditions improved further in the first quarter even though growth in real gross domestic product (GDP) appeared to have slowed... ...Consumer price inflation continued to run below the Committee's longer-run objective of 2 percent, restrained in part by earlier decreases in energy prices and declining prices of non-energy imports. Survey-based measures of longer-run inflation expectations were little changed, on balance, in recent months, while market-based measures of inflation compensation were still low...

Just as a side note the term ‘inflation compensation’ refers to the difference between the market value of inflation protected US Treasury issues, called TIPS, versus conventional Treasury issues2; it is viewed as reliable indication of expected inflation. The details are a bit complicated3 but it suffices to say that the market is indicating that they are equally valued; i.e. the compensation guaranteed by the TIPS is not enough to make them worth holding over the conventional issues. In other words, there’s little market expectation of appreciable inflation, at least in the near term. That being said, low inflation compensation has been noted in previous Fed statements and it has been an ongoing concern of the FOMC. Thus the Fed must be well aware that the bond market is not signaling at least near term inflation.

Also in the very first paragraph of the Economic Situation section, it’s clear that the employment situation seemed to be on-track; the committee noted continuing employment gains and in labor force participation. Specifically “...both the labor force participation rate and the employment-to-population ratio continued to increase... ... Labor productivity growth appeared to have remained slow over the four quarters ending in the first quarter of this year. Measures of labor compensation continued to rise at a modest pace...”  Real wage growth correlates with productivity gains and low productivity correlates with low wage inflation4. Hence, in spite of the ‘modest’ rise in wage compensation, continuing low productivity gains, if any at all, should well offset wage inflation concerns.

If low productivity gains indicates low real wage gains would the Fed act on the stronger than expected Q1 retail sale gains? The US economy is in large part consumer driven, so actual wage gains may be well below what is needed to sustained US consumer spending. US retail sales recorded the best gains since the previous year5 but could this be a one off? The question must be asked whether the Fed is willing to risk a rate increase after just one exceptional quarter when over the longer term retail sales may actually be driven by relatively low wages. It’s important to note that some stores have recently reported surprisingly weak earnings in spite of sales gains6. This might indicate price ‘roll backs’ in order to clear inventory.

So just in those first two paragraphs of the Economic Situation section there are enough uncertainties which indicate the risk of raising borrowing costs, especially at a point when discretionary income may just be gaining a sustainable toehold.

The Fed also noted concerns about a <I>too</I> strong US Dollar: “...Total industrial production declined in February and March. Manufacturing output decreased, partly reflecting the effects on export demand of earlier appreciation of the foreign exchange value of the dollar...”  This is an important point to ponder.