US interest rates: what next after payroll shocker

While one is tempted to attribute that weak December Labour Market report to seasonal factors or other one-offs, we certainly looked for anomalies, but could not find any. The numbers were bad. But let's move on because the outlook remains promising

Friday's US labour report was unambiguously poor. Payrolls rose only 1k in December, with downward revisions to both November (cut from 57k to 43K) and October (from 137k to 100k). Average weekly hours worked also fell from 33.9 to 33.7. The one positive is that the unemployment rate (based on the separate household survey) fell from 5.9% to 5.7%. However, the fall in the unemployment rate this month was due to people dropping out of the labour force, perhaps discouraged by the difficulty in finding a job. Employment in the household survey was essentially unchanged.

Those numbers are so out of line with the best leading indicators that it is tempting to look for a distortion. We have not found one. The usual suspect is poor seasonal adjustment. But as different seasonals are used for the payrolls and the household survey and as neither showed any job creation, that is unlikely to be the reason. It was a weak report, full stop. Looking forward, however, Friday's numbers will not matter one cent in a few months' time when the improvement in the leading indicators shows through into the hard data. That could come as early as January's report.

Our big picture view on the US is therefore unchanged. Indeed, taken as a whole, the December data has been strong enough to prompt us to revise our 2004 growth forecast to 5%. The leading indicators, such as the ISM, are simply more important for forecasting than the lagging indicators, such as payrolls. The unemployment rate remains the best measure of excess capacity and we expect it to continue to trend down. By the second quarter it should be a full percentage point lower than the (revised) peak of 6.3% back in June. That will support Fed tightening.

Core inflation will probably remain relatively low this year, rising to around 1.5% from the 1.1% recorded last November. If you believe that current inflation is the only thing that matters (as some do) then that could be used to justify keeping interest rates on hold. But our view is that you need to start by asking why rates are currently just 1%. It is not enough to say that rates are at 1% because inflation is low. Even allowing for the soft core CPI, the real Fed funds rate (the actual rate minus inflation) is exceptionally low. Rates are at 1% because of the fear of deflation. As that fear fades, rates should go up again. The average real Fed funds since 1985 is 2%. So a 'neutral' level, based on core inflation of 1.5% in 2004, would be around 3.5%.

The Fed will be in no hurry to get rates back to this level. We therefore expect the Fed funds rate to end 2004 at a level which is still accommodative, say 2.5% (50bp increases each in June, September, and November). The economy will inevitably weaken again at some point given the need for consumers to save more. That is most likely in 2005, triggered by fiscal tightening after the November 2004 presidential election. But we then expect a slowdown (to growth of around 2.7%) rather than a collapse. There is sufficient momentum that it would require a major shock (terrorism being the obvious candidate) to turn 5% growth into a recession. If the economy does indeed slow substantially next year, as we expect, rates are likely to go back on hold at 2.5% for 2005. If not, we would look for another 100bp of tightening in H1 2005, taking rates to 3.5% by the middle of next year.