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Powell’s speech today will be watched for any comments on trade turmoil
U.S. unemployment report expected to show further tightening in the U.S. labor market

Powell’s speech today will be watched for any comments on trade turmoil — The markets will be watching carefully to see if Fed Chair Powell in his speech today in Chicago on the U.S. economic outlook makes any comments about whether the recent tariff turmoil and stock market volatility is causing the Fed to have any doubts about its current rate-hike plans.

The current view at the Fed seems to be that the trade turmoil bears watching but is not serious enough as yet to cause the Fed to seriously rethink its rate-hike regime. Regarding the stock market, the Fed generally believes that the stock market was overvalued anyway so most Fed officials may actually be pleased with a 10-15% downside correction. On the other hand, if the U.S. stock market were to see a 1987-style crash (i.e., a -30% drop in a week) on an all-out trade war, then the Fed would be forced to halt its rate-hike plans and its balance-sheet drawdown program and would probably have to promise renewed easing.

Two Fed officials have already admitted that the trade turmoil is causing some anxiety. Fed Governor Lael Brainard on Tuesday said that trade policy is “a material uncertainty” to the outlook. She said it difficult to predict how the trade outlook could evolve but that “it’s certainly something that I take into account, in thinking about risks.” Meanwhile, St. Louis Fed President James Bullard on Wednesday said that trade policy “does present some downside risk, but generally speaking it is too early to tell what the actual impact will be on the U.S. economy.”

The recent trade turmoil and stock market weakness has caused the markets to mildly pull back their expectations for Fed rate hikes through 2019. Specifically, the market is now expecting a further 85.5 bp of rate hikes (i.e., 3.4 rate hikes) through the end of 2019, according to the Dec 2019 federal funds futures contract. That is down by -9 bp (or about a third of a rate hike) from the peak of 94.5 bp (3.8 rate hikes) seen just two weeks ago.

However, the recent turmoil has not caused the market to downgrade its expectations for a 100% chance of a Fed rate hike at the meeting after next on June 12-13. That rate hike would push the funds rate target up to 1.75-2.00%. We believe that the FOMC will be chomping at the bit to implement at least one further rate hike before year-end to push the funds rate up to 2.00-2.25% even if the trade and economic outlook later this year looks a little choppy. If the Fed pushes the funds rate up to a midpoint target of 2.12% by later this year with two more rate hikes, then the inflation-adjusted real funds rate will finally be in positive territory relative to the Fed’s 2% inflation target for the first time in more than a decade. Once the FOMC has done away with a negative real federal funds rate, then it can move more slowly with the process of raising rates towards its longer-term target of around 3.00%.

U.S. unemployment report expected to show further tightening in the U.S. labor market — The market is expecting today’s U.S. March unemployment report to show a solid labor market, which would encourage the Fed to keep up the steady pace of its interest rate hikes to ensure that the labor market does not start to overheat. The U.S. unemployment rate has been at a 17-year low of 4.1% for the past five reporting months, which is well below the Fed’s estimate of a long-term natural unemployment rate of 4.5%.

Despite the low unemployment rate and tight labor market, wage pressures remain relatively tame. The consensus is for today’s March average hourly earnings report to edge higher to +2.7% y/y from Feb’s +2.6%. Hourly earnings rose to an 8-3/4 year high of 2.8% y/y in January, but then fell back to +2.6% in February. As long as wage growth remains under control, the Fed will not worry too much that a tight labor market will push inflation higher.

However, the Fed is predicting that the U.S. unemployment rate will fall from the current 17-year low of 4.1% to 3.8% by the end of 2018 and then to 3.6% in 2019-2020. A 3.6% unemployment rate would be a hefty 0.9 points below the Fed’s estimate of a long-term natural unemployment rate of 4.5%, which is more likely to put upward pressure on wages. The market consensus is that today’s March unemployment rate will fall by -0.1 point to 4.0%, which would be a new 17-year low.

The market consensus is for today’s March non-farm payroll report to show an increase of +189,000, which would roughly match the 12-month trend average of +190,000. Payroll growth has been very strong in the past two months at +239,000 in January and +313,000 in February, which means there could be some payback in March. Yet job growth in general remains impressive this far into the business cycle. The U.S. economy in the current 9-year expansion has produced an enormous 18.451 million new jobs since the labor recession trough was posted in Feb 2010.

Labor market strength is finally being seen even in the U.S. manufacturing sector. U.S. manufacturing jobs started to show some signs of life in late 2017 with a 6-month average monthly increase in manufacturing jobs through January, rising to a new 20-year high of 27,000 jobs. That means that U.S. manufacturing jobs since late 2017 have shown the most strength since 1998. That is particularly important since manufacturing jobs typically pay substantially more than service jobs, which is important for boosting overall U.S. worker income. The consensus is for today’s Mar manufacturing payrolls to show an increase of +24,000 jobs after February’s strong report of +31,000.

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