Monday, April 5, 2010

The Employment Data and the Fed

With the March employment report representing a clear turning point in underlying labor market trends, the question quickly becomes whether the time frame for Fed tightening ahead have changed in a material way.

The answer is, probably not.

The moderate back-up in Treasury yields since Friday is understandable, but a less emotional look at the configuration of the current environment continues to point to the fourth quarter of the year as the earliest plausible timing for the Fed to start tightening. In a nutshell, there are three key parameters that will determine when the Fed will feel confident enough to initiate that process:

1) The strength of the real sector economic data.

On that score, things are looking up recently, with the manufacturing sector leading the way and increasing evidence that consumer spending is turning up as well. The labor market statistics (not simply payrolls, but jobless claims as well) are also improving steadily but at a still unimpressive pace. Inasmuch as it is encouraging to see a 100,000+ plus private payroll gain for March and initial claims resuming recently their previously stalled downtrend, both series continue to reflect a profound slack in labor market conditions. (The 9.7% unemployment rate can vividly corroborate that picture). It would be both an analytically dubious- and, politically, simply untenable- decision by the Fed to start tightening within the first six months or so of the first credible signs of a discernible, but slow, turnaround of the still poor employment picture.

2) The price outlook.

Core inflation continues to drift lower, with both the core CPI and PCE deflator currently at 1.3% on a year-on-year basis. While it is true that inflation tends to be a lagging indicator, the reality is that they key price data should continue to inch lower in the balance of the year, therefore providing a very favorable backdrop against which the Fed will be contemplating its next step. In fact, by the Fed's own forecasts just six weeks ago ( ), core inflation could move closer to 1% by year end. Nobody questions the premise that monetary policy has to be anticipatory and not wait for inflation to accelerate in order to apply the brakes. But with a very considerable slack in the economy to be absorbed over time and inflation drifting lower, it is exceedingly hard for the Fed to rationalize a more restrictive policy during that period.

3) The state of the banking system.

Although the healing process of the banking system has come a long way from the scary days of the fourth quarter of 2008, the industry's lingering vulnerability is pointedly reflected in the ongoing reluctance of banks to engage in more historically "normal" lending practices. The latest Fed loan officers' survey showed, for the first time in more than two years, lending standards not being tightened further (, but this still leaves them at disconcertingly tight levels. This not only continues to represent an impediment to the pace of the economic recovery gearing up significantly in the foreseeable future but it also minimizes the risk of any inflationary impulses resulting from the excess liquidity in the system (not much lending, no inflation)- hence, it buys time for the Fed to allow the recovery to roll unimpeded for a while.

The decision as to when the Fed will move to the more substantive face of its exit strategy (the first phase, which consisted of shutting down the various liquidity facilities has already been largely completed, after all) will hinge on a set of factors that are far more complex than the relative improvement in the employment data.

True, the March employment report raises the Treasury market's anxiety level a couple of notches but it has not moved up materially the time when the Fed will take action validating that anxiety.

Anthony Karydakis