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What the Employment Report Means to the Fed On March 5, 2010 the Bureau of Labor Statistics released its monthly employment report for February. Overall, the report beat the market’s expectations. The employer survey showed a loss of only 36,000 jobs which is small considering the extreme weather in the northeast. Additionally, the unemployment rate held steady and the household survey showed an increase of 308,000 jobs. Certainly good news for the economy, but in the bond universe the most important question is: what does this mean to the Fed? The Federal Reserve has a dual mandate to facilitate price stability and full employment. Therefore, the Fed’s actions are driven by three factors:
In the last six months, employment has stabilized, inflation has picked up and the Federal Reserve’s outlook has become more bullish. As a result, many market observers have suggested the Federal Reserve will soon raise interest rates. However, this may be premature as inflation is still historically benign and employment statistics have not shown dramatic gains. So what is the probability that the Federal Reserve raises interest rates this year? Obviously, the answer depends on how the economic recovery progresses, but an analysis of previous interest rate cycles indicates that higher interest rates are likely several months away. CCM has developed a model based on the actions of the modern Federal Reserve which uses statistics of employment, inflation and various economic indicators to estimate the probability of Federal Reserve actions. This model indicates that even under optimistic economic conditions, the Fed is unlikely to hike interest rates until November. The following graph shows the probability of an interest rate hike at the Fed’s 2010 meetings under three different scenarios.
Employment is the key factor which will determine whether the Federal Reserve raises interest rates. The next graph focuses on the Fed’s meetings in June, September and December and shows the estimated probabilities under various employment scenarios.
Even if the economy adds 500,000 jobs per month from now until June, the chances that the Fed raises rates are slim. By September, the economy needs to add around 350,000 jobs per month to make an interest rate hike 50/50. In December, Federal Reserve action appears far more likely but still not a sure thing. With 120,000 jobs per month (the long-term average for the U.S. economy), an interest rate hike is about 50/50 but even with 300,000 jobs per month, there is still a 21% chance that the Federal Reserve takes no action. The counter-argument to this evidence is that the Federal Reserve has never been so accommodative with monetary policy in the past. Therefore, they would raise interest rates sooner than historic evidence suggests. However, in 2003 the Federal Funds rate was 1%, a historic low at the time, but the Fed waited until mid-2004 to raise interest rates. By that time the U.S. economy had added 3.1 million jobs2 since employment had bottomed in 2002. Currently, the economy has only created 849,000 jobs since the 2009 bottom. Additionally, Federal Reserve Chairman Ben Bernanke may be especially apprehensive about raising interest rates. As one of the world’s foremost scholars on the Great Depression, he is acutely aware of the Federal Reserve’s mistakes during the 1930’s. After the economy was decimated from 1929-1932, a robust recovery followed from 1933-1936 and the Fed began tightening monetary policy in 1936. But the nascent recovery could not handle tighter money and the economy suffered a second severe downturn in the second half of 1937 and first half of 1938.
In conclusion, the Federal Reserve is very unlikely to raise interest rates before August. Furthermore, only in the most bullish economic scenario would the Fed be raising rates in August or September. Not until November or December does Fed action become plausible depending on economic developments between now and then.
Endnotes: i Source for Federal Reserve Probabilities: CCM Calculations
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