The Federal Reserve says there "remains significant underutilization of labour resources." That's the new explanation for why the Fed's benchmark interest rate must be kept at zero for longer. It's going to be a tough sell.
"We grown increasingly vocal over recent weeks that the Fed continues to run policy best suited for the Great Recession, yet by any measure economic activity has evolved beyond that point with growth running above potential and much of the slack in the system having been absorbed," the New York-based U.S. economics team at RBC Dominion Securities advised clients Wednesday.
Led by chief U.S. economist Tom Porcelli, RBC this week brought forward its forecast for when the Fed will raise the Fed funds rate to June, 2015, from October, 2015. It's an aggressive shift that shows just how quickly perceptions of the U.S. economy are changing on Wall Street.
The data are as consistently strong as they have been since the end of the recession. As they sift through this week's evidence, some analysts are saying the Commerce Department's initial estimate of economic growth in the second quarter – an annual rate of 4 per cent that was much stronger than most were expecting – may have been underestimated. The argument that the Fed is behind the curve was strengthened Thursday when the Labor Department reported that the number of initial claims for jobless benefits declined by 14,000 to 289,000 last week from the previous one. That dropped the four-week moving average to 293,500, its lowest since February of 2006. A figure below 350,000 is generally seen as signalling a decline in the unemployment rate.
Before the recession, there would be little doubt about the timing of the Fed's next move. But Janet Yellen has done a good job since taking over as chair in February of re-educating the public on the markers that will guide her over the next couple of years. The standard measures of economic strength – the unemployment rate, non-farm payrolls – matter less. Inflation is contained. As long as it stays that way, Ms. Yellen sees no reason to hurry the return to a more typical policy setting when more granular measures of the labour market show there are weaknesses. The standard unemployment rate is falling quickly, but another measure that includes part-time workers who wish they had full-time work remains elevated. There is ample evidence that older workers stranded by the recession are finding it difficult to get jobs. Ms. Yellen thinks policy can help these people and she believes she is obliged to try. The majority of the Fed's policy committee is with her.
Everyone on Wall Street knows where Ms. Yellen stands. Not everyone agrees. The point of contention centres on how fast the U.S. economy can grow without stoking inflation. Gross domestic product for the past few years has advanced about 2 per cent a year. That's nothing to get excited about by historical standards. But what if historical standards no longer apply? The financial crisis and demographic changes appear to have diminished the potential of the U.S. economy. That means a "lacklustre" growth rate of 2 per cent could be about as much as America can handle without stoking inflation. RBC's Mr. Porcelli thinks GDP has been advancing faster than its new potential rate – which he puts at about 1.2 per cent – for the past several years.
"This reality makes 2 per cent look like a victory and augurs for a scaling back of monetary easing sooner rather than later," Mr. Porcelli said.
The reason to pay attention to these growing doubts about the Fed's plans is that financial markets will become volatile if the balance shifts in favour of the doubters. Interest rates could rise without the Fed doing anything at all if investors decide inflation is imminent. The Kansas City Fed's annual symposium at Jackson Hole, Wyo., at the end of August has become an important moment on the Fed calendar. It's an opportunity for the Fed chair to correct misconceptions or signal a new course. That will be no different this year. Ms. Yellen is scheduled to speak in Jackson Hole on Aug. 22. Circle the date. She will have some explaining to do.