The Federal Reserve’s Path To Higher Interest Rates

The Federal Reserve will be keeping a close eye on the Non-farm payrolls this month.

The Fed plan to plough ahead with a reduction of its balance sheet, but the outlook for further rate hikes is more muddled. Therefore, this month’s job report is even more crucial in understanding the policy path the Fed will take in September.

August will be spent trying to decipher whether the Fed will be driven my inflationary weakness or the low labour market.

We cannot describe the labour market as overheated, with stagnant wage growth inflationary growth will struggle. Regardless, central bank members believe the labour market is strong enough to withstand a hike to the cost of borrowing, at 4.4% unemployment the economy is outperforming the bank’s medium estimate of the natural rate of unemployment of 4.7%.

The Fed are notoriously optimistic, failing to reach forecasts for years, its take on the unemployment rate is no exception.

Members believe that the unemployment rate will remain steady in 2017. If the NFP comes in as expected, at 180,000, this will be consistent with the 187,000 average across the year. The Fed’s reasoning suggests that growth of this kind will vastly overshoot the natural rate of unemployment thus pushing the inflation rate close to its 2% target.

This however, is naïve. Unemployment rates have remained at low levels for some time now, without stimulating wage growth. Wage stagnation has kept inflation levels low. The reason for this? The labour participation rate. Many of those able to work are unwilling thus, there is the unemployment rate is skewed as the slack in the labour market remains high.

Nevertheless, if there is a drop-in unemployment to the 4.3% region, the Fed will retaliate by hiking rates as its sees this as an overheated labour market that needs to be quenched.

However, the Fed cannot ignore persistently low wage growth. If July’s report reiterates the sluggish wage expansion we’ve seen so far this year, we could see the Fed mark down its natural rate of unemployment and therefore we could see members put the brakes on rate hikes until 2018.