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Fed’s Labour Market Outlook Faces Credibility Test as Politics Further Encroaches on Policy Conduct

The Federal Open Market Committee’s (FOMC) latest economic projections indicate that the unemployment rate will not decline below its current 4.3% in 2017. Despite above-trend economic growth in 2017, expectations of an unchanged unemployment rate in H2 would suggest the FOMC believes the economy has already reached full employment.

Fed Chair Yellen believes a flat civilian labour force participation rate, due to ageing demographics, is the most plausible outlook for labour supply, thereby casting doubt on the conviction of the FOMC’s flat unemployment rate projection. Meanwhile, the FOMC appears reluctant to significantly lower its forecast for the natural rate of unemployment or change its policy reaction function, thus indicating a dogmatic approach to policy normalisation.

Chair Yellen is aware that the risks of unemployment undershooting 4.3% are high and the hawkish tilt to policy will remain, despite low inflation. In addition to the commencement of Fed balance sheet reduction, another twenty five basis points rise in the federal funds rate should be expected in 2017, along with three similar increases next year.

Currently, President Trump has three vacant positions to fill on the Fed’s Board of Governors, but these need to be confirmed by the Senate. Furthermore, Fed Chair Yellen’s and Vice Chairman Fischer’s current terms expire next year, thereby potentially implying even more personnel changes that will necessitate a new consensus in implementing US monetary policy.

Historically, financial markets have taken a dim view whenever personnel changes at the Fed are deemed to be purely in order to execute political agendas. Failure to execute major parts of his election manifesto before the mid-term elections could persuade President Trump to pressure the Fed to slow policy normalisation in 2018 via dovish new appointments to the Board of Governors.

Currently, US banks hold a much higher proportion of cash assets compared to before the financial crisis that has been supportive for US equities. Meanwhile, quantitative easing has had the unintended consequence of boosting the attraction for banks to hold higher levels of securities within overall bank credit at this stage of the economic cycle. Meanwhile the secular stagnation thesis embraced by bond investors suggests a sharp spike in yields that could provoke aggressive liquidation by banks is unlikely.