US Bond Market Week in Review: The Fed Should Let Wages Rise A Bit More Before Hiking Rates

Last week, I argued that due to weaker economic data since January 1, the Fed should hold off on raising rates. However, over the last few weeks, several very credible commentators argued that higher inflation readings would put a rate hike into play. While inflation measures are increasing, rising wages are the primary reason for the increase. And as the US labor force is just beginning to see meaningful wage increase (which should support increased consumption expenditures), the Fed should still withhold rate increases for now.

Before looking at the data, let’s explain two key points. The first is, “why does the Fed focus on core inflation rates as much as total inflation?” Several sets of prices – most notably food and energy costs – are very volatile. For example, suppose the yearly wheat crop’s total yield drops by 15%. Prices would increase. But the next year, farmers would increase wheat plantings to take advantage of the higher prices. Supply would increase, lowering prices. These events would lead to an 18-24 month arc in food prices, which would increase overall inflation. The core rate, however, may not rise nearly as much, if at all, for a number of reasons.And if the core rate doesn’t rise, an analyst will think costs are contained – that the wheat price spike’s effect was limited to that one market. 

Other markets – like copper – have longer cycles. Over the last 4-5 years, raw material extraction companies several very large projects that are currently flooding the world with raw materials. These projects continue producing to help pay for their massive cost. Like the shorter seasonality of the agricultural markets, longer price arcs exist for these materials. But, all these prices will eventually gravitate back towards a statistical norm. These wide price vacillations may or may not seep through to other prices.If they don’t, then we’ll see a wide divergence between core and total CPI, which is what the Fed is hoping for. But, if there is a higher degree of correlation, then the Fed gets nervous, and may be more inclined to raise rates.

Finally, several Federal Reserve banks have developed alternate, “trimmed mean” CPI measures to separate the signal from the noise.  The Dallas Fed has the following very good explanation:

In spite of the arcane-sounding name, the concept of a trimmed mean is a simple one. In fact, trimmed means should be familiar to any follower of international figure skating. In the wake of the controversies surrounding the judging at the 2002 Winter Olympics, the International Skating Union adopted a scoring system in which a skater’s highest and lowest marks are discarded before the skater’s average score is calculated. Trimmed mean inflation rates are derived by a similar procedure.

In any given month, the rate of inflation in a price index like the Consumer Price Index or Personal Consumption Expenditures (PCE) can be thought of as a weighted average, or mean, of the rates of change in the prices of all the goods and services that make up the index. Calculating the trimmed mean PCE inflation rate for a given month involves looking at the price changes for each of the individual components of personal consumption expenditures. The individual price changes are sorted in ascending order from “fell the most” to “rose the most,” and a certain fraction of the most extreme observations at both ends of the spectrum are—like a skater’s best and worst marks—thrown out, or “trimmed.” The inflation rate is then calculated as a weighted average of the remaining components.   

In essence, a trimmed mean number assumes that a certain percentage of the highest and lowest readings are statistical noise and should be discarded.

Let’s move to the figures, starting with this chart from the Cleveland Fed:

The chart shows the core and total rate for CPI and PCE. The overall figure for both measures is now trending higher from levels right around 0 while the both core rates are moving slightly higher. Lower energy prices are the primary reason for lower rates. But, none of these figures shows an impending inflationary spike. Also note the deflationary pressure from the low overall rates doesn't appear to be seeping into the core rates.

Next, here is the Cleveland Fed’s trimmed mean CPI:

The one month rate is the most volatile, with readings fluctuating between 1.5% and 2.2%. The 6-month rate is a bit smoother, with readings between 1.6% and 1.9%.And the 12-month figure is smoother still, ranging between 1.7% and 1.9%.

The core CPI and PCE rate along with various trimmed mean measure are increasing, leading some commentators to argue the Fed should increase interest rates. However, as this table from the Atlanta Fed shows, wage increases are the primary reason for the uptick:

  

Three baskets – producer prices, material/commodity prices and inflation expectations are very low. Retail prices are about normal while money are credit causes are running a bit hotter.The main basket behind rising prices are rising wages. But wages are just starting to meaningfully rise, as the following four from the CFA Institutes Enterprising Investor blog demonstrate:

The upper left graph shows U6 and U3 unemployment rates must each reach certain threshold levels before wages start to rise. The upper right chart is from the JOLTs survey and it shows more people are voluntarily leaving their job – a sign increased confidence. The bottom two charts are from the NFIB’s monthly survey of small business and both show employers are experiencing increased difficulty finding employees, which is leading them to increase wages. 

The data indicates wage pressure are the primary reason for rising inflationary pressures. But those pressures are just starting to occur. And considering the weak wage environment US workers have been in for most of this expansion, the Fed should let them run for the foreseeable future.