Fed State of Play: Strength of Economy Keeps Dec Hike in Play

--Balance Sheet Announcement in Sept FOMC Likely Done Deal

--Continued Job Growth, Spending, Investment Growth Should Boost Dec Hike Odds

--Aug Jobs Report Weaker Than Expected But 3-Mo Avg 185K Close to 2016 Levels

By Jean Yung

     WASHINGTON (MNI) - Federal Reserve officials haven't ruled out a December

interest rate increase and a rash of positive data this week should cement plans

to start reducing the balance sheet this month and boost back up expectations

for a third hike this year. 

     Continued growth in hiring and a strong pick-up in consumer spending and

business investment reflects momentum in the U.S. economy at the start of the

second half of the year. Friday's jobs report was slightly weaker than analysts

expected. Even so, the economy created 156,000 new jobs in August and roughly 2

million slots in the past year. 

     The unemployment rate ticked back up to 4.4% and average hourly earnings

gains over the past 12 months clung to the lackluster 2.5% pace seen since

April. The lack of faster wage growth continues to frustrate Fed policymakers,

though MNI understands that a majority on the Federal Open Market Committee

still views the Phillips curve relationship as intact and supporting continued

policy normalization.

     Earlier this week, the Commerce Department also revised second-quarter GDP

growth higher to 3%, the strongest quarter in more than two years. The Atlanta

Fed's latest GDPNow forecast sees growth accelerating further to 3.2% in the

third quarter.  

     All that positive news on the economy should support another step in

removing monetary accommodation, starting with pulling the trigger on the

earlier announced blueprint for allowing assets to gradually roll off the Fed's

balance sheet. But futures markets are pricing in just a 41% chance of another

hike by year-end, according to the CME Group's FedWatch tool, largely because

inflation continues to underperform.

     Both headline and core consumer inflation as measured by the personal

consumption expenditure price index were 0.1% in July and just 1.4% over the

past year, the core slowing from 1.5% in June, the Commerce Department said

Thursday. Inflation hit 1.9% several times late last year and earlier this year

but has been held down by one-off factors and base effects since then. 

     "You would have expected given that we're getting tighter labor markets

that we'd have a little higher inflation. I think that what that gives us is the

ability to be patient," Fed Gov. Jerome Powell said last week. 

     Several other regional Fed bank presidents have echoed that sentiment, and

Fed Chair Janet Yellen focused her highly anticipated speech in Kansas City

Fed's Jackson Hole conference last week on financial stability without dropping

any hints about what the FOMC might do in the coming months. 

     She opted not to link easier financial conditions to higher rates, which

would have signaled an elevation of the role of financial stability plays in

decisions on monetary policy, instead calling for a strong regulatory framework

to contain the financial imbalances that may emerge in long periods of low

interest rates.  

     Other FOMC members in interviews indicated they are ready to begin the long

process of winding down the Fed's balance sheet at the Sept. 19-20 meeting but

would wait to see how the economy performs while mulling the timing of the next

rate hike. 

     Economists will also be sorting out Hurricane Harvey's impact on the

economy over the next few months. Houston is the fifth largest U.S. metropolitan

area by economic output, producing about 2.5% of GDP. The hurricane will likely

result in lower employment and output in the near term, but in the long term

will likely boost output and inflation as the area rebuilds. 

     A potential government shutdown if Congress does not raise the statutory

U.S. debt ceiling by the end of the month would be a "major shock to the

economy," Powell said. But he also stressed he was optimistic that that would

not happen and said the Fed would have to see how that plays out as it prepares

to wind down the balance sheet. 

     "Our outlook is that we anticipate further increases this year and next

year for the federal funds rate," Fed Chair Janet Yellen said at her June press

conference. 

     "Our statement indicates that we expect inflation to remain low in the near

term. But, on the other hand, we continue to feel that with a strong labor

market and a labor market that's continuing to strengthen, the conditions are in

place for inflation to move up." 

     She continued: "With policy accommodative, all that we're doing in raising

rates is removing a bit of accommodation heading toward a neutral pace. And I

see that as appropriate."

     Another appropriately timed quarter-point increase, perhaps by the end of

the year, would go a long way in that direction.  

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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