Fed: behind the curve, or too trigger happy? Neither

July 15, 2015

?????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????????As the U.S. Federal Reserve edges closer to its first interest hike in nearly a decade, its critics are lining up into one of two camps: either the Fed is hopelessly behind the curve, and will have to grapple with runaway inflation very soon; or the Fed seems overzealous in wanting to get interest rates back to what it would call a normal level and instead should wait until late this year or next before hiking.

The last thing it wants to do is to make a false start.

A simple chart measuring some of the most basic but crucial economic variables explains a lot. Weekly first-time claims for unemployment benefits have tumbled to the lows they last reached during the boom from the stock market bubble of the late 1990s. They are below where they were at the height of boom times during the peak of the real-estate bubble that preceded the worst global financial crisis and recession since the Great Depression.

US jobless claims and Fed rates

The difference is that in the past, the fed funds rate was either at or near its peak during these times as well.

Why does this simple comparison matter? Jobless claims are one of the most reliable indicators around as they are a head count of real people making claims and not a representative survey of the job market. Claims can only go so low in an economy with a moderately-increasing population in a job market with regular turnover. 

And a trough in jobless claims, as one would expect, usually precedes a recession just around the corner. Central bankers tend to start cutting rates from their peak just beforehand, as the chart going back 30 years shows.

Jobless claims hit a low of 268,000 in mid-June and since have crept back up to 297,000. The unemployment rate has tumbled to 5.3 percent, although the pace has slowed in recent months, suggesting the improvement in the labour market may be waning. The unemployment rate is now getting close to past lows that preceded a period of rising joblessness and subsequent interest rate cuts.

Going on past experience alone, it’s tough to see why the Fed didn’t start raising rates a long time ago. Indeed, the current level of jobless claims suggests that we are much closer to the end of the expansion than the beginning. In normal times, rates would now be around their peak.

But the financial crisis changed everything.

Not only did the Fed cut rates to zero after Lehman collapsed and brought the economy down with it, but the central bank has spent most of the past half decade purchasing vast quantities of government and mortgage bonds, adding some $3.5 trillion worth of securities to what it already owned.

So not only have the policy peaks gradually declined over the past quarter century, at the moment, the interest rate trough is still flat-lining with a bloated balance sheet.

We all know the main explanation for why rates haven’t gone up.

There haven’t been enough signs yet to worry central bankers that very low inflation — a global phenomenon — is set to rise sharply and stay high. The historic plunge in oil prices that began about a year ago and brought about deflation in some major economies was followed by a tepid rebound. Renewed weakness in commodity prices suggests that global demand is not picking up sharply. Plenty question the official China data which suggest that economic growth in the world’s largest purchaser of crude oil hasn’t slowed at all. China’s central bank has cut rates four times since last November and inflation there is just 1.4 percent.

So a rate hike from the Fed, however late it may seem to be getting around to it, seems out of step with the rest of the globe.

Even the Bank of Canada, the central bank for the U.S.’s closest trading partner, just cut rates unexpectedly to 0.5 percent, and for the second time this year.

When the Fed does begin a series of hikes – an escape act from zero rates and quantitative easing that has never before been successfully performed by any central bank – Chair Janet Yellen has made clear that she does not think the Fed is behind the curve, either intentionally to ensure a vigorous recovery, or accidentally.

“Indeed, the stance of monetary policy will likely remain highly accommodative for quite some time after the first increase in the federal funds rate in order to support continued progress toward our objectives of maximum employment and 2 percent inflation,” Yellen told Congress on Wednesday.

If the stage we are currently at for jobless claims is any guide, it may already be too late.

— Graphic by Vincent Flasseur

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