The Federal Reserve left Fed funds unchanged at 5.25% in yesterday’s FOMC meeting, although the spectre of inflation still haunted the accompanying statement. The FOMC “judges that some inflation risks remain,” the central bank advised. “The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”
That evolution, by one analyst’s reading, all but assures more rate hikes are coming. Charles Dumas, an economist in London at Lombard Street Research, expects a fresh round of monetary tightening. The crowd thinks otherwise, but Dumas is steadfast in his contrarian view. His reasoning: “there’s excess demand [in the economy,] which tends to create inflation pressure,” he told CS on Tuesday.
Dumas explained that the unemployment rate is “below trend” at 4.6%, which is almost a full percentage point lower than is consistent with noninflationary growth. He added: “The [relatively low] rate of unemployment now will produce 1% more wage growth per year than will be offset by productivity.” Simply put, a jobless rate that’s nearly a percentage point below trend tends to produce faster wage growth, which he predicts will lead to higher inflation. The Fed, as a result, will be forced to raise interest rates to nip the trend in the bud.
As Dumas wrote in a research report published the day before our conversation (the report that initially inspired us to call):
…the “neutral” rate of unemployment is 5-1/2%: on my analysis of past trends, this is the rate that leads to real hourly compensation growth of 2 to 2-1/4%, i.e., the rate that matches hourly output growth in the economy. But current unemployment of 4.6% is nearly 1% below this level [see graph below]. And a deviation from neutral of 1% for unemployment generally implies 2 to 2-1/2% for output, as profits rather than labor absorb much of the effects of fluctuations in output and incomes. Yet the output gap [in the economy] we measure is zero.
Source: Charles Dumas, Lombard Street Research
An output gap of zero implies that inflation will be contained. But Dumas thinks the jobless rate will nonetheless dominate going forward for two reasons. One, core CPI consumer price inflation is now running at nearly 3% in the U.S. Second, hourly compensation has been “heavily revised upward,” he wrote in his research note. He went on to explain:
The latest quarterly number for hourly compensation is up 7-3/4% from the year before – an obviously ridiculous number as it implies unit labor cost gains of 5% or more, and yet much lower prices increases have not stopped profits booming. But even if
the eventual number is half-way back to the pre-revision rate of only 3%, such a 5-to-6% gain in hourly pay is consistent with 3% or so for unit labor costs – in other words, higher core inflation is being “baked in.”
Perhaps, although the crowd isn’t worried at the moment. Or so it appears based on Fed funds futures this morning. The next FOMC comes on December 12; judging by the December contract, the consensus remains convinced that Fed funds will remain unchanged at 5.25% once the dust clears from the next meeting in December.
In fact, there’s no shortage of economists predicting that the economy will continue to soften and that the rationale for holding rates steady, if not cutting, grows stronger over time.
Nonetheless, there’s more than enough conflicting data to keep the debate alive in some corners. The future’s always unclear, and arguably it remains a little more so than usual.