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Fly Fishing for the Next Rate Hike

Chief U.S. Economist Ellen Zentner parses Janet Yellen’s comments at Jackson Hole to try and clear up the noisy and still muddy economic and policy outlook.

I hope Federal Reserve Chair Janet Yellen took the time to do some fly fishing in the wake of Jackson Hole. For me, nothing clears the mind so completely as being on the water and focusing on the matter at hand. To be successful at fly fishing, you have to shut out all the noise (with the exception of the rushing water and screaming eagles on the hunt).

If Yellen opened a newspaper, surfed the Internet, or glanced at a TV screen after her appearance Friday, she no doubt was bombarded by a cacophony of voices, including a good dose of criticism and varying media interpretations. Let's step back for a more objective read. Here is the relevant passage on the economy and current stance of monetary policy:

Indeed, in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months. Of course, our decisions always depend on the degree to which incoming data continues to confirm the Committee's outlook.

Based on the labor market alone, the case for further rate hikes has strengthened, but the same cannot be said for economic fundamentals and price stability. Moreover, further rate hikes are predicated on the extent to which the incoming data confirm the Fed's outlook, an outlook that it will likely have to mark down at its September meeting, given weak data on corporate profits, productivity, and inflation. While market probabilities for rate hikes ahead have risen in the wake of Jackson Hole, another rate hike this year remains far from certain.

Job Market Strength

Clearly, the U.S. labor market matters. Although trend job growth has slowed—from a torrid monthly average of 282,000 in the fourth quarter of 2015, to 196,000 in the first-quarter and 153,000 in the second quarter of 2016—that is normal, as the labor market tightens and business expansion ages. Moreover, trend job growth remains above the level needed to keep the unemployment rate steady—the so-called "breakeven" level largely believed to be between 80,000 and 100,000 monthly.

At 4.9%, the U.S. unemployment rate is sitting very near the Fed's level of joblessness below which inflation rises. Finally, if our forecast for August payrolls is borne out in the data, through the first two months of the third quarter, average job growth will have picked up its pace to 188,000. All this underscores how one side of the Fed's mandate—the health of the labor market—appears locked in.

What about the outlook for economic activity and inflation? Based on the revised reading for second-quarter GDP, the U.S. economy averaged a bit less than 1.0% annualized growth in the first half of 2016. This paltry pace has challenged the consensus and the Fed's own full-year forecasts—1.8% and 2.0%, respectively—and threatens even our well-below-consensus forecast for 1.6% growth this year. However, third-quarter GDP has started out tracking stronger-than-expected; we currently peg it at 2.8%.

Sifting through the details, it’s important to note that this tracking estimate includes an 0.9 percentage-point contribution from inventories, as well as business investment, which has finally swung to positive growth. Although at just 0.5%, it’s a terribly tepid pick-up, following three straight quarters of decline. Excluding the positive swing from energy infrastructure investment, overall business investment looks to be declining again in the third quarter.

GDP vs. GDI

When policymakers meet Sep 20th-21st, they will need to debate the underlying fundamentals supporting growth, not just whether growth has picked up in the second half of the year. The weakness in business investment has spread beyond its start in energy, and global growth uncertainty and uncertainty surrounding the U.S. presidential election are more broad-based drags to take into account.

Corporate profits and gross domestic income (GDI) should also be red flags. The second-quarter GDP revision revealed that after-tax profits fell by an annualized 9.3% for a year-over-year decline of 6.3% and a decline of 11.8%, since the third-quarter 2014, peak. With the exception of 1986 and 1951, this kind of protracted decline in earnings has typically been associated with recessions.

This weakness in corporate profits has contributed to poor growth in GDI, which averaged just 0.5% over the first half of 2016. In principal, GDP and GDI measure the same thing, economic output, though from different sides: spending vs. income. Because spending data lags behind income data, annual benchmark revisions ultimately will reconcile GDP to GDI, which suggests that first-half growth may be weaker than the current 1.0% measure of GDP growth.

Declining Productivity

Meanwhile, productivity, one of Yellen's important "persistent headwinds," implies that r*, the real equilibrium rate of interest, hasn’t picked up as hoped. In an important speech earlier this year, Yellen noted that r* was about flat and policymakers expected it to rise gradually, as persistent headwinds fade, looking to align the target rate with that gradual rise. Since then, productivity has declined by an annualized average of 0.6% in the first half, after averaging growth of just 0.5% over the past five years through 2015. The lack of a pick-up in r* should lead reasonably minded policymakers to question the need for further rate hikes at this time.

This is a good opportunity for me to reiterate our Fed call from earlier this summer, when we underscored our expectation that the Fed has moved to the sidelines, until incoming data convince us that r* has finally begun to rise.

At its coming September meeting, the Fed will need to mark-to-market and lower its growth forecast for the year. It will also need to revise lower its forecast for the economy's longer-run potential, given its current estimate of 2.0%, which implies an expectation that productivity turns around significantly to 1.5% from a well-entrenched trend of 0.5%.

Stubbornly Low Inflation

The Fed is clearly missing on the inflation side of its dual mandate. This year, growth in core personal consumption expenditure (PCE) inflation, a key gauge of pricing pressures stripping out volatile food and energy prices, is set to come in below the Fed's 2% goal for an eighth straight year. More recently, year-over-year growth in core PCE likely hit its high note of 1.7%, earlier this January. Since then, it has declined to 1.6%, where it has stayed stubbornly flat for five straight months.

At Jackson Hole, Yellen stressed that another rate hike will depend on "the degree to which incoming data continues to confirm the Committee's outlook.” The lack of growth in core PCE inflation is unlikely to help boost confidence, particularly in light of an economy growing below its potential, with ultralow productivity and declining corporate profits.

What’s the single most important development that would keep the Fed from raising rates further? I would point to the historically low level of market-based measures of inflation compensation and inflation expectations. The Fed staff's 5-year/5-year gauge was at 1.42% (vs. a record low 1.30% in July), as of Aug 24th, and no doubt has moved lower still. The University of Michigan survey reported record low five-year consumer inflation expectations. The Fed Board of Governors is chock full of academics who are practicing monetary policy in theory. Everything they've learned and taught in a lifetime of practicing economics says that, if inflation is low and inflation expectations are falling, you don’t touch rates lest you embed those expectations lower. This is what strikes fear in the hearts of monetary policymakers.

Adapted from recent Morgan Stanley Research commentary “In the Wake of Jackson Hole" (Aug 28, 2016). Ask your Morgan Stanley representative or Financial Advisor for the latest coverage on U.S. economics and policy outlook. Plus, more Ideas.