Trends in wages growth over the next 2-3 months will be crucial in determining whether the Fed pushes ahead with plans to keep raising short-term interest rates. Core FOMC members are banking on stronger growth to push inflation higher but, without acceleration, the dovish members would be in a much stronger position during the autumn period.
Dallas Federal Reserve President Kaplan stated that he had to weigh the policy trade-off carefully at last week’s Federal Reserve policy meeting. Although he was comfortable with the decision to raise interest rates again he wanted evidence of higher inflation before sanctioning another rate increase over the next few months.
Minneapolis Fed President Kashkari issued a detailed explanation for his decision to dissent against last week’s decision to raise interest rates. His core argument was that inflation has been lower than expected and that he was not convinced that the recent weakness in inflation was due to one-off factors.
In this context, he stated that the Fed should have waited for further evidence before sanctioning another increase.
New York Fed President Dudley took a more hawkish tone with comments on Monday that the increase in average earnings was likely to accelerate to the 3.0% area over the next year or two and that inflation was likely to increase.
In this context, he stated that it could be dangerous to halt the Fed tightening cycle now.
The battle lines have, therefore, been drawn within the Federal Reserve Open Market Committee and the inflation trends will be extremely important in the short term.
The FOMC does have significant room for manoeuvre given that the median forecast is for rates to be increased only once more during the remainder of 2017.
There is, therefore, certainly scope for the FOMC to leave interest rates on hold at the September meeting and pencil in a December move. The committee would also have scope to concentrate on balance sheet reduction at the September meeting.
Developments surrounding earnings growth will be a key focus over the next few months. Although the decline in unemployment to the lowest level for over 10 years suggests that the labour market remains very tight, there has been only very limited acceleration in earnings growth with an annual increase of around 2.5%.
If wage growth accelerates over the next few months, the Fed will be much more comfortable in raising interest rates further. The key issue is likely to be whether there is a lagged impact from the tight labour market with wages growth gaining strength or whether structural factors are maintaining downward pressure on both earnings growth and inflation.
There will also be an important global dimension which will need monitoring in the short term. If global trends in wages growth and inflation remain notably subdued, the Fed will be more wary in sanctioning a further tightening of monetary policy.
If there is evidence of higher global inflation, the Fed will also be much more comfortable in raising rates.
The ECB is concerned that overall inflation pressures remain weak despite a strengthening in growth and there has been an increasing focus on trends in wages with commentary that developments in earnings growth will be very important for underlying monetary policy trends.
The Bank of England has been surprised that earnings growth has been so subdued despite the tight labour market and rising employment.
Recent trends in global financial market conditions still suggest that monetary policy is not too tight with US equity indices close to record highs. If equity markets maintain a very strong tone during the summer period, global central banks will also be more comfortable raising interest rates. Indeed, it may be seen as essential to trigger a more sober attitude surrounding equity valuations.