Fed Dilemma: Jobs vs Wages

Latest data don't clear the picture...

AFTER a wobbly few sessions, investors breathed a sigh of relief as US jobs data came out at the end of last week, writes John Stepek at MoneyWeek magazine.

It seemed to confirm that the "Goldilocks" scenario is intact. On the one hand, jobs growth remained solid; on the other, inflation remained placid.

Not too hot, and not too cold. Just right, in fact.

But are they right to relax?

On Friday, US jobs data came in very strongly, saying the US economy added another 313,000 jobs. That was the biggest rise in 18 months. On top of that, the figures for the previous two months were revised higher, by a total of 54,000.

The strong figure was partly down to January's data being hit by cold weather and the flu epidemic, notes Capital Economics. But in any case, it was much better than the 200,000 expected, and another sign that the economy continues to be strong.

The big question of course is: what about wages?

Wage inflation is the biggest trigger for markets to start worrying about a) Federal Reserve interest rate rises and b) inflation taking off and changing the face of the investment environment.

Which is probably why markets reacted with such relief when the annual wage growth rate fell back from 2.8% to 2.6%. If workers can't make a pay rise stick, then it suggests there must be more slack in the system, which means the Fed won't have to raise rates much further, which means the cheap-money stockmarket party can continue for a while longer.

One sign that this process might have further to run is how the participation rate improved. In other words, there were fewer "discouraged workers" – people who give up the hunt believing that they effectively have no hope of finding a job. If more people are getting back into the pool of potential employees, then that is another source of slack.

Big sigh of relief all round. However, markets probably shouldn't get too relaxed just yet.

As Paul Ashworth of Capital Economics points out, despite the latest respite in February, the pace of wage inflation seems to be picking up. If you look at the last three months compared to the same three months last year, the rate of inflation has now picked up from 2.6% to 2.9%.

That sense of acceleration was confirmed in the latest Federal Reserve "Beige Book" survey which noted that "most districts saw employers raise wages and expand benefit packages in response to tight labour conditions".

Meanwhile, as Eoin Treacy notes on FullerTreacyMoney.com, any moderation in wages over the last month ignores a vital point – the effect of the most recent tax cuts on take home pay.

In effect, notes Treacy, US workers got an extra pay rise in their January pay packets because of the tax cuts. That'll take some pressure off their employers – but not for long. "That's enough to keep wage demand growth under wraps for a quarter or two, but not indefinitely."

In short, there are plenty of signs to suggest that we'll see higher US wage inflation – it's only a matter of time.

The bigger question is this – what will the Fed do about it?

There's a lot of dancing around as to whether the Fed will raise interest rates three times or four times this year.

I don't really think this is all that relevant to investors. It's part of the minutiae of markets. It's not really about how many quarter-point rises the Fed ends up doling out over the next 12 months.

It's more about whether the Fed increases interest rates faster than inflation rises, or makes sure to stay lagging behind.

That's a trickier question.

The Fed's ideal – and it must know this – has to be to lag behind. We've come out of a big debt deflationary bust. The world is still carrying a lot of debt. The easiest and least socially painful way to get back into a less precarious position is to inflate that debt away.

That's a tightrope though. If the Fed is too relaxed about inflation, then it could end up with serious problems. The market may drive up interest rates anyway, and if it feels the Fed is slacking off, the US could have problems offloading the many billions of Dollars of US Treasuries it needs to sell this year.

What makes the Fed's job harder is that Donald Trump is now embarking on expansionary fiscal policy, which is also inflationary. As a result, the Fed probably has an incentive to tighten a bit faster than it would have.

On the other hand, the classic event that the Fed wants to avoid is that it raises rates "too far, too fast" and tips the economy back into recession. Avoiding this outcome was the guiding principle of both Ben Bernanke and Janet Yellen, and I'd be surprised if none of that institutional memory has rubbed off on Jerome Powell.

My view remains that the Fed will want to err on the side of caution. Within that, the "three or four rate hikes" question is something of a red herring. If you're talking about 0.25 points a pop, then the federal funds rate is still only going to be about 2.5%, which would easily lag behind inflation.

So the real question is more this: will something happen to drive the Fed wildly off course? Will inflation start to rise strongly, causing the Fed to raise rates more vigorously? Or will the market have a horrible panic that persuades the Fed to ease off? Or both?

My gut feeling remains that inflation will be what drives all the surprises this year. And so I'd stick with the "late-cycle" narrative (buying the likes of mining stocks, for example, to get exposure to commodities). And hang on to gold, just in case.