Review & Outlook, June 2017

The Federal Reserve (Fed) is likely to raise interest rates at its June meeting, despite a softer May jobs report. Markets continue to anticipate only modest further rate increases over the next 18 months. The December 2018 fed funds futures contract currently has an implied yield of 1.49%, while the two-year U.S. Treasury yield holds near 1.30%. Both yields imply the Fed will pause in the rate hike cycle following their likely June move.

Short-term yields reflect market expectations that the Fed will begin reducing the size of its balance sheet as its next policy move, after lifting the policy rate by 1% over the past 18 months. Yields also reflect prospects for continued subdued economic growth, slowing employment gains, decelerating inflation and declining longer-term inflation expectations.

The Labor Market Is Near Full Employment

Payroll growth has slowed this year. The May employment report showed an average gain of only 121,000 jobs over the trailing three months and 161,000 jobs over the past six months. These are the slowest job growth trends on a smoothed basis for the past five years.

Payroll Growth Has Slowed in 2017

Data source: Bureau of Labor Statistics, 6/1/12 - 5/31/17

Despite this slowdown, the unemployment rate reached a new cyclical low of 4.3% in May, the lowest rate in more than 16 years.  Labor force participation fell in May, driving the decline in unemployment.

Most measures suggest the labor market is at or very near full employment. Monthly payroll gains in excess of 125,000 jobs per month will likely be the exception rather the norm going forward due to limited growth in the number of available workers. If the recent slowdown in employment gains was exclusively due to labor supply constraints, wage gains would likely be accelerating.

Unemployment Is the Lowest in More than 16 Years

Data source: Bureau of Labor Statistics, 1/1/92 - 5/31/17

Wage growth held steady over the past year, suggesting that labor demand has likely moderated as well. Employment in the manufacturing, retail trade and construction sectors has been softer in recent months. Employment data correspond with data showing below-peak auto sales and disruption in the retail space. Construction spending has also been softer, but this is likely payback for a surge in winter activity due to abnormally good weather.

Economic Growth Moves Slowly but Surely

The monthly purchasing manager indices covering both the manufacturing and service sectors paint a picture of an economy that continues to move slowly but surely forward. In addition, the Fed's Beige Book of anecdotal reports on economic activity from business contacts indicated the economy continued to expand at a modest to moderate pace through late May. Most updated estimates of second quarter gross domestic product (GDP) growth are centered at slightly more than 2%.

Inflation measures will likely experience downward pressure near term due to sagging energy and commodity prices. More broadly, core inflation measures have declined in recent months as rental pressures eased and other service prices decreased. These developments, along with declining longer-term inflation expectations, are causing concern about the intermediate-term inflation outlook among at least some Fed officials. But as long as financial conditions continue to ease - a weaker dollar, lower long-term yields and higher stock prices - the Fed will likely remain biased to tighten further, as this data implies a positive impulse to future economic growth. The Fed is also becoming more concerned about asset valuations, which will contribute to the bias to tighten further if these market trends continue.

The economy appears to be generally tracking our growth forecasts through the first several months of the year. First half GDP appears on track to increase between 1.5% and 2.0%. This trend will likely continue in the second half of the year unless significant tax policy changes are implemented.

Unemployment has declined faster and further than anticipated in recent months, causing the Fed to accelerate its schedule for rate increases. Job growth should remain modest and unemployment should hold steady in the months ahead. Inflation will likely move lower, in part due to the rebound in energy prices last spring. If oil prices remain steady, they will begin subtracting from consumer price indices in June. But the Fed is expected to remain biased for further normalization, likely through balance sheet policy, until financial conditions begin to tighten.