UBS: How will the Fed react to weaker data?

In a speech this week, US Federal Reserve Chair Janet Yellen clarified her thinking on the economy and theoutlook for Fed policy following last Friday’s surprisingly weak labor report, which showed payroll growthin May slowing to its lowest level since 2010. While Yellen called this “concerning” and repeatedly notedthe uncertainty in the economic outlook, overall she was cautiously optimistic.

When thinking about monetary policy, it’s importantto focus on the Fed’s dual mandate: maximum employmentand price stability, where stability is defined as a 2% inflation rate. Yellen stated, “I believe we arenow close to eliminating the slack that has weighed on the labor market since the recession,” and “I expectinflation to move back to 2%” as the impact of lower oil prices and the strong dollar fades. The big picture,then, is that the Fed is still on track to fulfilling its mandate.

Further, Yellen repeated previous comments that the “neutral” fed funds rate is around 1 percentage point above the current rate, and that it would likely rise over time. Yellen has also said many times in the past that she wants to hike rates at a gradual pace. Given that they are already well below neutral and the Fed is very close to fulfilling its mandate, we can only conclude that the Fed will want to raise rates in the months ahead unless bad news obstructs that path. However, before hiking again, Yellen will want to verify that the payroll slowdown seen in May is only temporary.

This probably rules out a June hike, and also makes July unlikely, since there will only be one more laborreport released before the July Federal Open Market Committee meeting. By the time of the September meeting, there will be three more labor reports, which should be sufficient to justify a hike as long as payrolls grow fast enough to diminish labor market slack further. Based on Yellen’s previous comments on the relationship between population growth and labor supply, something above 100,000 new jobs per month should suffice. Of course, other economic data, especially on inflation and wage growth, as well as financial market conditions, will also influence the Fed’s decision. 

We think that even mediocre data would be enough for the Fed to hike in September. A July hike is still possible if the economic data between now and the meeting is very strong. In either case, another hike should follow in December, as long as the economic recovery remains on track.

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