It is not easy to bring in a plane for a soft landing when your instrument panel is giving you conflicting signals and you are running out of fuel.
This is the challenge facing not just the Federal Reserve, but also a growing number of systemically important central banks around the world. The U.S. jobs report for May, which will be released Friday, may help clarify some of the signals, but unfortunately, the overall policy context is likely to remain unusually fluid.
Having stopped its quantitative easing purchases in an orderly fashion, the Fed is embarked on raising interest rates from abnormally low levels -- with markets attributing a 90 percent probability of a hike this month, the second of the three that the Fed has signaled for this calendar year -- and on formulating its approach to shrinking a $4.5 trillion balance sheet. All this is part of its desire to “normalize” monetary policy after too many years of excessive reliance on experimental unconventional measures.
The Fed is undertaking this delicate and unprecedented maneuver in the context of unusual developments in national politics and geopolitics around the world. Adding to the challenge is conflicting economic data that, rather than clarify, accentuate some key unresolved questions relating to productivity, wage dynamics and the behavior of inflation. These questions are illustrated in the mother of all data releases, the monthly U.S. jobs report.
For quite a while, the report has documented a sharp fall in the unemployment rate in the context of solid employment creation that has added more than 16 million jobs since the last recession. With that, the widely-followed U-3 unemployment rate has fallen all the way to 4.4 percent, a level that neither the Fed nor the majority of forecasters had expected.
Yet this has not been accompanied by the wage growth that many would have anticipated based on historical models and widely accepted economic relationships. Nor has it induced a material recovery in the labor participation rate, with tighter employment conditions failing to attract back discouraged workers. And all this interacts with the unusually sluggish productivity and inflation dynamics.
The Fed is not the only central bank facing such a situation. The European Central Bank is also getting there, as the euro zone experiences both a falling unemployment rate (the lowest since 2009) and stubbornly muted inflation, including last month’s fall in core inflation to an annual rate of 0.9 percent.
The traditional policy inclination in the face of competing data and less-than-illuminating historical and analytical models is to go slow, thereby retaining appropriate policy flexibility and optionality. And this is what central banks have been doing. But this, too, is not without challenges.
As former Fed Chairman Ben Bernanke observed in August 2010 -- when he signaled the pivot in the use of unconventional policies (from normalizing dysfunctional financial markets to pursuing macroeconomic objectives) -- it is about the trifecta of “benefits, costs and risks.” And because the Fed is using a tool that is ultimately ill-suited for the task at hand, the longer the U.S. economy relies on unconventional monetary policies, the lower the benefits and the higher the collateral damage and unintended consequences. The latter two include the risks of excessive financial risk-taking by market participants; inappropriate resource allocation; distorted asset class correlations; damaging low volatility; and, directly for central banks, greater institutional vulnerability to political interference.
Against this backdrop, Friday’s report is likely to confirm the high likelihood of a 25 basis-point hike when the Federal Reserve announces its next policy decision on June 14. Indeed, it would take a really awful report, including job creation well below 80,000 and slowing wage growth, to materially alter this likelihood. Conversely, a strong report, with no material rise in the participation rate, would increase the implied market probability of the subsequent hike being in September, currently estimated at just 20 percent.
In addition to shedding greater light on the potential for the next couple of rate hikes, the upcoming policy announcements will signal the Fed’s desire to unwind its balance sheet in a very slow and boring fashion. And it will do so while reminding us that it retains the option to alter course if economic conditions warrant it.
Friday’s report could also help economists and policy makers make some progress in understanding the productivity puzzle -- for example, insofar as it sheds more light on the compositional changes in job creation, particularly between the tradeable sector and the less productive/remunerated non-tradeable sector. But it is unlikely to resolve the puzzle in any decisive manner.
For that, we need a much better understanding of the structural changes to growth, labor demand and price determination. As a result, central banks will continue to face competing signals and need to worry about the risk of a hard landing, which bond markets understand but stock markets seem to have discounted to a very large extent.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE. He was chairman of the president’s Global Development Council, CEO and president of Harvard Management Company, managing director at Salomon Smith Barney and deputy director of the IMF. His books include “The Only Game in Town” and “When Markets Collide.”
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