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Low Wages Tie the Fed's Hands

Written By Briton Ryle

Posted December 4, 2014

Want to know what the Fed will do next? Don’t we all. Yesterday we may have received some very telling economic reports that often offer up great insights into the Federal Reserve’s possible next moves.

Yesterday’s reports are often used to predict the state of the employment report which follows two days later on the first Friday of the month, tomorrow. In turn, tomorrow’s jobs report is used to predict what the Federal Reserve will do at its next meeting, as economists have been attempting to do since the economic recovery began in early 2009.

Yet each time economists attempt to use these reports to guess the Fed’s next move, they always seem to underestimate the Fed’s determination to stay the course and not budge from its highly accommodative stance.

As we are now just two weeks away from the Fed’s next meeting on the 16th and 17th of this month, and with talk circulating for months that the FOMC could pull the trigger and start raising interest rates at any meeting now, what do yesterday’s reports reveal the Fed might do?

Will it cave-in and give the masses what they want, higher interest rates so that banks, pension funds and other fixed-income investors can finally earn a decent return? Or will they doggedly hold firm, not budging a single basis point?

Let’s see what yesterday’s reports could be foreshadowing.

ADP Employment Report

First up at 8:15 am yesterday came the monthly employment report published by economic research firm ADP, showing that new private-sector hirings reached +208,000 new hirings in the month of November, down a little from the prior month, hitting its lowest level in three months, and second lowest level in seven months, as per the graph below.

ADP employment figures chart

Although the general consensus was expecting 223,000 new hirings, the number isn’t a terrible miss, and is still sustaining that comfortable 200,000 monthly trend that has been in place for well over a year.

“At this pace the unemployment rate will drop by half a percentage point per annum,” Mark Zandi, chief economist of Moody’s Analytics which prepares the monthly report using ADP’s data explained.

If you recall, the Federal Reserve had long stated that an unemployment rate below 6.5% would be a “threshold” for implementing interest rate hikes to bring rates back to their normal levels. With the unemployment rate already at 5.8% last month, and with another half a percentage point expected per annum, as Zandi referenced, we are well within the territory which the Fed said would make raising rates acceptable.

However… references to that 6.5% unemployment rate “threshold” have been conspicuously absent from the Fed’s press releases and comments for several months now. Indeed, there are other factors which play a much more important role in influencing the Fed’s decision.

One of them is wages.

Productivity and Labor Cost Report

A few minutes after that slight miss on private-sector jobs came another miss on employee wages in 8:30’s Productivity and Costs report.

While the economy’s nonfarm productivity for Q3 was revised up to +2.3% from the previous Q3 reading of +2%, the longer term readings showed a slight slowdown in productivity. For instance, output growth this Q3 at +4.9% was slower than Q2’s +5.5% growth rate.

Year-over-year readings also showed a slowdown. Productivity grew +1% from last year’s Q3 to this year’s Q3, representing a slowdown from the +1.3% growth enjoyed from last year’s Q2 to this year’s Q2.

Yet even more relevant to any Fed rate hike discussions will likely be the report’s readings on wage changes. After wages fell in Q2 at an annualized rate of 3.7%, they again fell in Q3 by an annualized 1%. Year-over-year, wages were up only 1.2% from Q3 of last year to this Q3.

While this is an improvement in wage growth since Q2’s year-over-year growth of 0.7%, it still falls short of keeping pace with inflation which has been averaging an annualized 2% for a year already.

Equity Markets Are Going to be Happy

Add all this data together and what do we get? A Federal Reserve that will be reluctant to budge from its dovish, low-interest rate, cheap-money policy. Even though tomorrow’s new nonfarm employment number is expected to report that 235,000 new nonfarm jobs were created last month, and that the unemployment rate has come down another 0.1% to 5.7%, even such a report will likely not do anything to sway the Fed when it meets in two weeks’ time.

Why? Because inflation cannot be sustained as long as wages keep lagging behind. In the end, there is only one thing that will keep higher prices from falling back down again: consumers must be earning more in order to pay more. Inflation may be running at 2% for now, but if wage growth keeps lagging below the inflation rate, prices will ultimately fall back down again as consumers simply cannot afford the higher costs.

If the Fed even remotely suspects that the current inflation rate at 2% is unsustainable over the longer term, it will not raise interest rates, for doing so would only make the U.S. dollar stronger, which slows inflation all the more.

Besides, have you tried exchanging dollars into another currency lately? Have you noticed how powerful the USD has become over the past few months? If the USD remains this strong, and if wages remain this weak, there is no way inflation can remain at 2%.

A strong currency and weak wages are anti-inflationary, acting as two forces pushing prices down. Rising interest rates is also anti-inflationary, acting as a third force keeping prices down. The Fed does not want prices to stay down, but wants them to rise at 2% per year, even a little more to as much as 2.5% per year to make up for all the lost time since the 2008-09 recession.

Hence, if we already have two anti-inflationary forces at play (a strong USD and weak wages), the Fed is not about to introduce a third anti-inflationary force in the form of higher interest rates.

That means there is no way this equity bull run is going to end any time soon, as low rates to equities is like a straight-away with no stop signs to a racer: it’s a license to run.

If tomorrow’s jobs number is even just a little weak, look for equities to begin their next leg higher, as all expectations for an interest rate hike at the end of the FOMC meeting later this month will be completely off the table.

Joseph Cafariello