What’s the outlook for US monetary policy in 2018?

The Federal Reserve have raised the cost of borrowing, despite persistently low inflation. Policymakers decided to hike short-term interest rates for the third time this year and signalled more increases will follow in 2018 and 2019.

With the US economy at full employment and robust global growth, sluggish inflation may hinder the string of further rate increases scheduled for 2018.

There are a lot of variables at play, each with the potential to offset the impact of declining unemployment. If the Fed ignore these other components, the body is making a large bet that the economy is close to overheating and that to keep growth steady, the economy requires a tightening of monetary policy.

Components such as inflation, the natural rate of unemployment and neutral interest rate all play a major role in the estimations of future rate hikes.

Given the lofty price valuations and subdued wage growth the Fed may have to reduce its expectations. The Fed is notoriously optimistic in its analysis, often overshooting expectations and missing targets.

One of the main facets of the Feds equation is the low rate of unemployment. But just how reliable is the unemployment rate?

For those steering the nation’s monetary policy low unemployment is a great indication of economic health, although it does not tell the full story.

The labour participation rate, which should be closely examined when conducting analysis and deciphering whether the US has truly reached such low unemployment.

Described as the percentage of able and willing Americans who are an active part of the labour force – the labour participation rate is somewhat depressed. While, US wage growth is slacking, there is no driving force pulling workers back into the labour force. This means that the unemployment rate could be slightly skewed by the lagging wage stimulus.

The capacity of the labour participation rate and the extent by which government policy can pull the remaining population into the labour force should be paramount to any analysis of future rate increases. Are there additional people who could still be pulled back into the workforce?

Yes, probably. There is a large number of able workers are not being included in the workforce, many of them men aged 25-54 who are neither working or looking for work. Additionally, given the high cost of childcare in the US, many women never return to work after having children as the costs are too high.

Thus, the Fed are navigating the US economy towards tighter monetary policy with a faulty compass. Will the US economy be able to absorb the extra windfall?