Confused if the Fed will hike rates in September, or December, or never? Don't worry, the Fed is just as confused, at least until NY Fed's Bill Dudley has his biweekly meeting with Goldman's chief economist Jan Hatzius at the Pound & Pence, where over a lobster club, the current Goldmanite tells the former Goldmanite what to do. Which, if the most recent note just released by Goldman is any indication, means that the Fed will sorely disappoint all the "Septemberists", as Janet Yellen will opt for a December rate hike instead.
We're Still Decembrists
1. The economy continues to grow at a steady above-trend pace. Our current activity indicator (CAI) logged a healthy 3.0% gain in July, the top end of the 2.5-3% range seen for most of 2015. For once, the GDP data send a similar signal, as Q2 is likely to be revised up to around 3% and Q3 is tracking 2.4%. This growth pace should support continued healthy employment gains in the 200-225k range.
2. But we think there is still a ways to go before full employment. The best evidence is the stubborn weakness in hourly wage growth. With the employment cost index for Q2 and average hourly earnings for July in hand, our wage tracker stands at just 2.0%, far below the 3.5% rate we would expect if the economy were at full employment. To us, this reinforces the case for measuring the employment side of the Fed's dual mandate using broad measures of labor utilization. The employment/population ratio is still 4 percentage points below its level of early 2007, and we can explain only half of this shortfall with the aging of the US population. The wage data suggest that a significant portion of the other half may still represent cyclical labor market slack.
3. Admittedly, many Fed officials take a more optimistic view of the progress toward the employment side of the mandate. The July 29 FOMC statement indicated that only "some" further improvement was needed to meet the labor market criterion for funds rate liftoff. And Vice Chairman Fischer said on Monday that the economy was now at "nearly full employment." So why do we still expect liftoff to come in December rather than September?
4. The basic reason is that there are two criteria for liftoff, not just one. And while the two are not independent, it would be a mistake to overstate the strength of the link because the Phillips curve is so flat. This means that factors other than labor market improvement are potentially more important for the committee's confidence, including the actual wage and core price numbers, currency and commodity market developments, and inflation expectations. All of these are consistent with sustained below-target core inflation, even if the labor market continues to improve.
5. A more tangible reason to expect a late liftoff is that we think Chair Yellen sent a fairly clear signal in this direction back in June and early July. In particular, in her July 10 speech, she said that "unanticipated developments could delay or accelerate" the first hike. To us, this said clearly that her baseline expectation for this first hike was December, not September; after all, it was not really possible as of July 10 to "accelerate" a September baseline unless she meant to put a July hike on the table (not likely).
6. The question, then, is whether she and other members of the Fed leadership have seen any surprises that might cause them to change their mind. On the side of an earlier liftoff, core inflation is a tenth higher than it was a month ago (before revisions) and Greece seems to be on its way to resolution, at least for now. On the side of a later liftoff, wage growth has surprised materially on the downside and commodity prices have plummeted anew. On net, we think that information is at most neutral, if not a bit dovish at the margin.
Then again, considering that the vast bulk of Q4/Q1 GDP crushing snow falls right in December and January, we doubt the Fed will be so naive as to brave the elements and send the economy into a depression just when the ambient temperature drops to 20F or lower, and freezes the US economy for the third time in a row. Because nobody can ever anticipate winter's arrival...