As we embark on a new year, the consensus of economic forecasters seem to believe that the Federal Reserve will begin to raise interest rates in 2015. They point to the Fed ending the stimulus Quantitative Easing Program and the fact that interest rates have been so low for so long combined with the strength of the US economy as sure signs that rates will increase this year. Consensus seems to tell us if economic growth stays above 3% (currently around 5%) and core inflation rises above 2% (currently at 1.8%), the Fed will act to slow down the economy by raising rates.
Several items point to continued strength in the US economy. The Leading Economic Indicators and Purchasing Managers Index are both very positive. Housing starts, though not great, are quite a ways above the post-crash numbers. A lot of economic news is much better than things were in the last recession.
But have you ever stopped to ask, “What if they don’t raise rates? What signs point to the possibility of that not happening?” The Fed walks a tightrope with a long bar, balancing low unemployment on one side and price stability on the other. By price stability I mean low inflation. The Fed wants some inflation, but wants to keep it manageable. One of the worst issues a central bank could face is deflation, the state where prices of assets are going down. It makes it harder to pay off debt and also requires assets to be re-margined as their values fall compared to their debt.
The average person would say that the low unemployment rate of 5.6% in December, combined with an upward revision of the November payroll, points to us reaching a “full employment” stage that would set the Fed for raising rates. But a closer view of the numbers is warranted, which shows that while more people had jobs, they were making less money. Average hourly earnings fell by 2/10%, indicating that many of the jobs added are low-wage positions. A broader measure of unemployment, U-6, includes the unemployed, plus all persons marginally attached to the labor force, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all persons marginally attached to the labor force. This rate is falling but sits at 11.2% at the end of December.
The following chart from Agora Financial show the drop in unemployment since the recession has been accompanied by an increase in part time workers and a decrease in full time workers. Full time workers are down a good 2% since 2008, and part time workers are up the same amount. So as the unemployment rate goes down, a greater percentage of the employed are part time compared to where our country historically has been.
This is impacting wage growth as is shown in the following chart from the Bureau of Labor Statistics.
So more people are employed, but are under-employed or are in lower wage jobs. This is coupled with decreases in commodity prices we have seen in the last half of 2014. Oil, obviously gains the largest headline here, but other building materials like copper and lumber have also followed suit. Part of this seems to be the end of a commodity super-cycle. There are also indicators of a slowing demand from Europe and Japan. Emerging nations are seeing less economic growth, with half of them already in recession and the other half slowing down, Even China, is looking at growth rates half of what they have been used to in the last decade. The other factor present here is the strong US Dollar. As our dollar is stronger, we can buy more stuff. The strong dollar does make it harder to sell our exports, which could retard growth.
So in many ways, the US is like the best looking house in a bad neighborhood, in spite of the underlying weaknesses in our economy. But if the Fed raises rates, it will slow down the economy further. This may throw the economy back into a recession since deflationary pressures are strong. One item the central bankers like to avoid is deflation. Throwing us into a recession will also have a horrid impact on other nations that are teetering on the edge of one now.
Watch the Fed in the first quarter along with trends in core inflation, commodity prices, and the economic performance. Watch our economic growth but also look for clues that may uncover further weakness hiding below the surface. At the end of this year, we may once again talk about how the Fed left interest rates alone.