There is growing concern on Wall Street that there may be less slack in the job market than the Federal Reserve perceives, leading to a scenario where the central bank finds itself “behind the curve” with regard to winding down unprecedented levels of extraordinary monetary stimulus as inflation returns. Aneta Markowska, chief U.S. economist at Société Générale, writes in a note to clients that “Could the Fed hike rates in 2014?” is one of the top questions that has come up in recent meetings with investors. The Fed has kept the federal funds rate, its main policy tool, pinned in a range between 0 and 0.25% for five years in a bid to max out monetary accommodation, and it said in its latest policy statement on December 18 “that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.” According to the Fed’s own projections, that means the first rate hike likely won’t come until the end of 2015. The monthly release of official employment figures from the U.S. Bureau of Labor Statistics on January 10, however, revealed that the unemployment rate plummeted from 7.0% to 6.7% in December.
The proximity of the current unemployment rate to the Fed’s threshold is stoking the debate on Wall Street surrounding a potential scenario that has largely been lost in all of the negative sentiment toward the pace of economic recovery in recent years: what if the central bank’s own projections for prices and the labor market are too pessimistic, and justifications for continued stimulus are quickly waning? “Albeit 20 years ago, 1994 has not yet left the collective memory of markets, and the fear is that 2014 could see a replay hereof,” says Markowska. Key to the debate is to what extent recent declines in labor force participation — one of the drivers of downward pressure on the unemployment rate — are cyclical (i.e., reflecting economic weakness) versus structural (i.e., resulting from longer-term trends like demographics). If the decline in participation is largely cyclical, inflation is not a threat. If it is structural, then there will be a smaller pool of workers available to fill job openings as the economy picks up, and the risk becomes upward pressure on wages and inflation. More