Angelo Taningco
Economist, Treasury Group
The latest labor market and inflation data on the United States (US) have illustrated a relatively low unemployment on one hand and moderating inflationary pressures on the other hand, posing a concern for the Federal Open Market Committee (FOMC) in its upcoming monetary policy meeting on 13-14 June.

Figure: US Unemployment and Core PCE Inflation
Jan. 2016 – May 2017

 
The latest employment survey data of the US Bureau of Labor Statistics (BLS) shows US nonfarm payroll employment rising by only 138,000 in May, way below the market’s median forecast of 182,000 based on Bloomberg survey, and down from its April reading of 174,000. In addition, average hourly earnings of nonfarm employees rose by 2.5% year-on-year (yoy) in May, the same pace in April and the slowest growth since August of last year. Meanwhile, the latest BLS household survey reveals the US unemployment rate edging down to 4.3% in May from 4.4% in April with the latest print the lowest in 16 years; the US labor force participation rate falling for the second-consecutive month in May, leveling off at 62.7%; and the US employment-population ratio slipping to 60.0% in May from 60.2% in April.

These seemingly contradicting trends in the US labor market of falling unemployment, labor force participation and employment-to-population ratio; slowdown in employment growth; and stagnant wage growth, appear to signal a further tightening in the US labor market that’s likely induced by a shortfall of labor supply relative to labor demand with employers appearing to be less inclined to raise wages to a level that will attract new workers.

Meanwhile, US inflationary pressures have moderated in recent months as headline inflation based on the Consumer Price Index (CPI) and personal consumption expenditures (PCE) have dropped in March and further in April: the headline CPI inflation rate fell to 2.2% yoy in April from 2.4% yoy in March and 2.7% yoy in February and the headline PCE inflation rate declined to 1.7% yoy in April from 1.9% yoy in March and 2.1% yoy in February. Similarly, inflation excluding the volatile food and energy items has tapered off as well with both core CPI inflation and core PCE inflation falling for the third-consecutive month in April, leveling off at 1.9% yoy and 1.5% yoy, respectively. Moreover, US inflationary expectations have receded in recent weeks, with the Federal Reserve Economic Data (FRED) 5-year forward inflation expectation rate down to 1.89% yoy on 1 June from 2.04% yoy last 1 May.

This easing of inflationary pressures and inflation expectations doesn’t initially appear to jibe with the decline in unemployment. It is theorized that there exists an inverse relationship between inflation and unemployment, a.k.a., the Phillips curve, with low (high) unemployment leading to a high (low) inflation. However, anecdotal and empirical evidence have indicated a sharp decrease in the slope of the US Phillips curve since the 1980s, manifesting a weaker tradeoff between unemployment and inflation.¹ This has led both Federal Reserve Bank of St. Louis President James Bullard² and Federal Reserve Governor and FOMC member Lael Brainard³ to downplay the impact of lowering the unemployment rate in order to raise inflation. We estimate the correlation coefficient for the core PCE inflation, which is one of the more preferred inflation barometers of the Federal Reserve, and the unemployment rate to be at -0.52 spanning the January 2007 – April 2017 period, suggesting a potentially moderate negative correlation.

The FOMC’s dual mandate are maximum employment and price stability, with the former being estimated by the Federal Reserve’s equilibrium long-run unemployment rate (a.k.a., non-accelerating inflation rate of unemployment or NAIRU) of 4.7% and the latter being guided by the FOMC’s inflation target of 2%. Since the latest unemployment rate is already less than the equilibrium level, it is likely that the US economy is already at “full employment”, and thereby safe to say that the FOMC has met its maximum employment goal based on its NAIRU. In contrast, both headline and core PCE inflation have recently drifted farther below the 2% inflation target, and with inflation expectations also highlighting that future inflation will stay below the target doesn’t appear to assure the FOMC’s price stability mandate.

In its last meeting held on 2-3 May, the FOMC has agreed to keep the target range for the federal funds rate unchanged, and noted that their decision to maintain an accommodative monetary policy stance will support “some further strengthening in labor market conditions and a sustained return to 2 percent inflation.”⁴ However, since that meeting, inflation has drifted away from the target and employment growth became sluggish. Given these latest employment and inflation trends and following the FOMC’s data-dependent approach, we are of the view that the FOMC is unlikely to raise the federal funds rate in their 13-14 June meeting.

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