Investment Research — General Market Conditions
20 February 2015
Research US
Fed hiking cycle: an early start but a slow pace

The Fed will need to balance its dual mandate this year, with the labour market
improving fast but core inflation running below the 2% target.

The January FOMC minutes showed that there is no consensus on the
appropriate lift-off date. We believe the Fed will ultimately attach more weight
to labour market improvement and see through the current low level of inflation.

History has shown that wage inflation is not a good measure of labour market
slack. Postponing rate hikes until wages are rising risks falling behind the curve.

Optimal control models are used as an input in the FOMC’s discussion of rate
decision. These models suggest a fed funds rate of 0.5% in Q1.

Given our forecast of continued solid job growth, we expect the Fed to start a
gradual rate hike cycle this summer, most likely with a first hike in June.
Prepare for a summer rate hike
Our long-held view is that the Fed will deliver the first 25bp rate hike in June this year. We
still see a reasonable probability of a hike in June, but acknowledge that the low level of
core inflation and disagreement within the FOMC could postpone it to later in the year. The
January FOMC minutes showed that there is currently no consensus on the committee on
the appropriate lift-off date (see Flash Comment: FOMC participants are getting nervous ).
Even though many indicated that they would rather hike rates “too late” than “too early”
there was no exact guidance on the time horizon. We believe that the decision will be data
dependent. Here we expect the FOMC to ultimately attach more weight to continued labour
market improvement than the low level of inflation.
Overview of recent Fed speeches
We expect the Fed to hike rates earlier than the market is pricing but later than the
FOMC projected in December
1.2
FOMC December projection
Danske Bank primary forecast
Danske Bank probaility weighted forecast
Fed funds futures after Jan FOMC minutes
1
0.8
0.6
0.4
Source: WSJ
0.2
0
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Source: Bloomberg, Federal reserve and Danske Bank Markets
Important disclosures and certifications are contained from page 7 of this report.
Nov Dec
Senior Analyst
Signe Roed-Frederiksen
+45 45128229
sroe@danskebank.dk
www.danskeresearch.com
Research US
We think that the FOMC speeches following the very strong January employment report
give support to this view (see overview on previous page). We will likely be a bit wiser
next week when Janet Yellen delivers her semi-annual testimony on Tuesday 24
February. We attach the following probabilities of an initial 25bp rate hike to the
upcoming meetings: 17 June 50%, 29 July 20%, 17 September 30% (we attach a higher
probability to September than July because of the scheduled press conference).
Once the Fed starts the hiking cycle, we think they will take a gradual approach. With
core inflation running below the 2% target until late 2016, we think the Fed will deliver
around 100bp in rate hikes the first year. We expect the Fed to increase the hiking pace in
late 2016 where core inflation approaches 2% and the labour market has tightened
significantly. We present the arguments for our view below.
In contrast to our gradual hiking pace forecast, the market is pricing a slower hiking cycle
and a later start. This means that there is scope for higher market rates in the US over the
coming year.
Labour market improvement is significant
As is evident in the chart below, the labour market is currently in a better state on most
measures than when the Fed started the previous hiking cycle in June 2004.
Employer behaviour has been positive, with January posting the strongest three-month
job growth rate since 1997 and JOLTS data on job openings and hires much better than in
2004. Leading indicators, such as initial claims, the level of employment in the temporary
help service sector and the number of firms reporting that they were unable to fill job
openings (from the NFIB survey), are also encouraging.
Labour market in a better shape than when the 2004 hiking cycle started (outwards moves indicate stronger labour market)
Payroll employment
Temporary help services
employment
Leading
June 2004
June 2014
January 2015
Job openings
Employer
behavior
Unable to fill job openings
Hires
Initial claims
The index is
comparing the
labour market
conditions in
recent months
with June 2004
(Index=100)
where the Fed
initiated the latest
hiking cycle
Hiring plans
Job finding
Job availability
Part time for economic reason
Utilization
(slack)
Marginally attached
Quits
Confidence
Unemployment
Source: BLS, JOLTS, Macrobond Financial, Danske Bank Markets
Note: The figure shows the level of tightness of different US labour market key figures at different times, compared to the level of the same figures in June 2004
(Index=100). Counter cyclical figures (Unemployment rate, jobless claims, marginally attached, and work part time for economic reasons) are inverted, thus the higher
index (the further from the middle) the better (tighter) is the state for the labour market.
2 | 20 February 2015
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Confidence measures such as the share of firms in the NFIB survey that plan to increase
employment, the ‘plentiful jobs’ measure in the Conference Board survey and the number
of employees who left voluntarily are all close to or above the June 2004 level. What
stands out are the measures of utilisation or slack, which are generally weak. This suggest
that underemployment remains an issue even though the unemployment rate has dropped
from 10% at the peak to the current 5.7%.
Given the extremely low level of the fed funds rate, the current level of underemployment
is not enough to keep hikes off the table, in our view. It rather serves as a reason why the
Fed will initially keep the pace of hikes slow. Remember, at the time the 2004 hiking
cycle started, the fed funds rate was 1.0% and therefore closer to the long-term neutral fed
funds rate than is currently the case.
GDP and Danske Bank forecast
Source: BEA and Danske Bank Markets estimates
We expect GDP growth to reach 3.0% this year and 2.5% in 2016 (for details see
Research US: Revising down H1 GDP growth ). This is well above potential growth,
which the CBO estimates at 1.7% this year and should support continued job growth at an
average of 250,000 per month in 2015. Assuming a moderate pickup in labour force
growth, the unemployment rate should reach 4.9% by year-end.
GDP growth should keep payrolls at 250K on average this
year
Unemployment rate to reach new and lower NAIRU in
October
Source: BEA and Danske Bank Markets estimates
Source: BLS and Danske Bank Markets estimates
We find it likely that the FOMC will reduce its estimate of the NAIRU at the upcoming
March meeting, a guesstimate is from the current 5.4% to around 5.0%. If our forecast on
the unemployment rate is right, the NAIRU should be reached in October this year. We
think this is consistent with a fed funds rate in the range of 0.5% to 0.75%.
Core inflation to stay low but Fed to focus on the outlook
Trimmed mean PCE suggest a more
modest downward pressure on prices
One argument that is often referred to by the doves of the FOMC, is that there are no
signs of wage inflation and with core inflation running below the 2% target, the Fed
should wait to hike. We do not agree on this view, as we argue below, but it does give the
Fed a good reason to proceed gradually with policy normalisation.
First, it is true that core inflation, measured by the core PCE, is low and will likely remain
below the Fed’s 2% target until the end of next year. However, the Fed will respond to
the outlook for inflation and not the current level as highlighted by Chairman Yellen at
the press conference following the 16-17 December FOMC meeting (see Flash Comment:
FOMC meeting - It all depends on the data). Some of the factors dragging down core
3 | 20 February 2015
Source: Dallas Fed, BEA, Danske Bank Markets
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Research US
inflation now are likely to be transitory and reflect partly lower import prices and indirect
price effects from lower energy costs. Also, remember that in 1999, the FOMC began the
hiking cycle with core PCE at 1.4% y/y – not far from the current 1.3% y/y.
Survey-based longer-term inflation expectations have not moved much despite the current
low level of headline inflation and we think the Fed takes a lot of comfort in this.
However, there seems to be an increasing discomfort with the decline in market-based
inflation expectations. Since the January FOMC meeting, market-based inflation
expectations have stabilised, and with the oil price now stabilising and set to move
gradually higher during 2015, headline inflation and inflation expectations should bottom
in coming months.
5y5y forward breakeven inflation and
oil prices
Source: Bloomberg and Danske Bank Markets
Core PCE and forecast
Longer-term inflation expectations
Source: BEA, Danske Bank Markets estimates
Source: University of Michigan, Bloomberg, Macrobond Financial, Federal
Reserve
Note: Dark (light) shading indicates periods of tightening (easing)
Second, history suggest that wage inflation is not a particularly good measure of labour
market slack or underlying inflation pressure. There is a risk that policy makers will get
behind the curve if rate hikes are postponed until wage inflation is back at more normal
levels. This is the lesson from the past two recoveries following the 1990 and 2001
recessions. The charts below show the wage Phillips curve, defined as the relationship
between wage inflation and the unemployment rate starting in 1990 and 2000 respectively
and plotted for the following 7-8 years.
Phillips Wage curve 1990-1998
Wage Phillips curve 2000-2007
Wage Phillips curve 2008-2014 (Q4)
Source: BLS, BEA, Danske Bank Markets
Source: BLS, BEA, Danske Bank Markets
Source: BLS, BEA, Danske Bank Markets
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As is evident from the charts, wage inflation remains subdued despite a rapid
improvement in the unemployment rate following the recession. The exact same picture is
seen in current data. An explanation for this pattern is downward nominal wage rigidities.
Employers are hesitant to reduce wages and workers reluctant to accept wage cuts, even
during recessions. As the economy recovers, there is an accumulated stockpile of pent-up
wage cuts which has to be worked off before wages can start growing again. In response,
businesses hold back wage increases until inflation and productivity bring wages back to
near their desired level again.
The upshot is that wage inflation should not be taken as a better indicator of the degree of
slack in the labour market than the unemployment rate. Further, once the pent-up wage
decreases have been worked off, wage inflation tends to shoot up rapidly. Waiting to hike
the fed funds rate until there is clear evidence that wage inflation is moving higher would
risk the Fed falling significantly behind the curve, particularly when the starting point for
the fed funds rate is 0.125%. This risk was highlighted by Yellen in her Jackson Hole
Speech August 2014 with a reference to this research paper from the San Francisco Fed
which is also available in a more current version.
Wage pressures are rising in some
sectors
Source: NFIB, BEA and Danske Bank Markets
ULC suggest much more price
pressure than wage data
The minutes from the January FOMC meeting suggest that there is disagreement within
the FOMC on wage dynamics. However, with both Yellen and San Francisco Fed
President Williams (voter, centrist) calling for a cautious approach to wage inflation data,
we believe that the most influential members of the FOMC are in that camp.
Third, if we adjust the current low level of wage inflation for productivity growth and
look at unit labour costs instead, the message is that the low level of productivity is
putting upward pressure on production costs despite low wage inflation.
Source: BLS, BEA and Danske Bank Markets
Optimal control policy suggests rate hike now
The FOMC has stated several times that in order to facilitate a faster return to lower
unemployment the fed funds rate should be kept lower than under normal circumstances.
Optimal control policy path with 2012 and late 2014 data – compared to December
median of FOMC projections for the Fed funds rate
Dec FOMC projections
OC - Late 2012
OC - Late 2014
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
2022Q3
2022Q1
2021Q3
2021Q1
2020Q3
2020Q1
2019Q3
2019Q1
2018Q3
2018Q1
2017Q3
2017Q1
2016Q3
2016Q1
2015Q3
2015Q1
2014Q3
2014Q1
2013Q3
2013Q1
2012Q3
2012Q1
0
Source: Federal Reserve, Danske Bank Markets
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This has been supported by so-called Optimal Control (OC) models1 for monetary policy
which Chairman Yellen made reference to in her famous November 2012 speech. As she
highlighted, the optimal path for the fed funds rate under such a model suggested a
significantly later lift-off date for the fed funds rate than more simple approaches such as
a Taylor rule. The thinking is that in order to get the unemployment rate down towards
the long-term natural level fast, the central bank could allow the inflation rate to
overshoot the target for some time.
A recent note published on the Federal Reserve website shows the same OC model but
using current economic data. The model now suggest a much earlier increase in the fed
funds rate than back in 2012, with a first hike in Q4 2015.
Another interesting result from the model simulations is that an early hike followed by a
gradual increase in the fed funds rate is to be preferred over a later hike with a more
aggressive hiking cycle afterwards. This supports our view that the Fed will prefer an
early start to the hiking cycle followed by a gradual pace of increase afterwards.
1
Optimal control models for monetary policy basically estimate the policy that minimises the
policy makers’ loss function cumulated over time. For the Fed, the loss function is often defined as
a weighted average of inflation deviation from target, unemployment deviation from its long run
normal value and a loss from changes in the fed funds rate, which reflects a desire to avoid abrupt
changes in the policy instrument.
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Disclosures
This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske
Bank’). The author of the research report is Signe Roed-Frederiksen, Senior Analyst.
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