Last Friday, Professor Jeremy Siegel and I sat down with Richmond Federal Reserve (Fed) president Jeffrey Lacker. Given the strong March employment report delivered that morning, it was an especially timely conversation, focused around the timing to get off the zero lower bound interest policy rates.
Professor Siegel started the discussion by noting that we had seen six months of consecutive job growth and unemployment falling to a new cyclical low of 5.5%—very close to the Fed’s natural unemployment rate target. He suggested that this translates to less slack in the economy and raises prospects for the Fed raising rates.
On the back of this strong jobs report, interest rates on the 10-year bond spiked up from 2.11% to 2.25%. Higher bond yields put pressure on the U.S. stock market—as is often expected from a fair value exercise that incorporates a classic discounted cash flow perspective for valuing stocks.
Lacker discussed how the labor market was improving faster than expected. He pointed to the job flows: the JOLTS data showing job turnover was indicative of a stronger labor market. Job openings are up, job quits are up—which means people are willing to take a chance to get a new job and have confidence in their labor prospects.
What does this mean for Fed policy?
With a strong labor market report confirmation, June strikes Lacker as the leading candidate for liftoff from the Fed’s zero interest rate policy.
The market—judging by the Fed fund futures market—still hasn’t reconciled these views, as it’s still pricing in September for the first hike in rates. Lacker is doing his part to prepare the market for the shift in policy to occur sooner.
How might wage pressure, declining commodities and a strong dollar cause the Fed to run below its target of 2% inflation?
Lacker believes we need to focus on what real interest rate the economy needs to grow at a non-inflationary pace. In the 1970s, the Fed believed it needed a lower real interest rate to support the economy and did not get it right (the policy caused very high inflation). Lacker further believes the economy is picking up and the Fed clearly needs higher interest rates. Lacker said there are going to be fluctuations from 2% inflation (sometimes inflation will be as high as 4%, as it was a year ago, and sometimes it will be -1%), but if the Fed is confident the swings are transitory, then it can take volatility in inflation in stride.
Strong jobs…weak gross domestic product (GDP). What’s causing disappointing productivity?
Lacker believes the overall GDP headline number is pretty volatile due to inventory swings, net imports from oil and weak overall net exports. But Lacker takes comfort from consumer spending and business investment. The U.S. consumer is more confident in employment prospects and we saw consumer confidence surge in Q4.1
Productivity swings take a long time to decipher and understand. What Lacker hears from businesses are concerns on regulatory impediments (labor, environment, new regulations) and compliance issues making them cautious about investments.