While most people would classify Chairperson Yellen as very dovish, I’m more inclined to say she’s slightly dovish. The former description connotes that she’ll keep rates low despite signs of significant progress. But as shown in her June 6th speech, the economy is already close to what she would classify as full employment.
Let’s start by looking at what she classifies as “good” news:
Let me start with the positive. The increase in employment over the past several years has contributed to higher household incomes and strengthening consumer confidence. If the May labor report was an aberration or reflects a temporary slowdown resulting from the weakness in economic activity at the start of the year, then job growth should pick up and support further gains in income. In addition, rising equity and house prices have helped restore households' wealth. The fall in oil prices has supported household purchasing power as well. Simple calculations suggest that the average household has gained some $1,300 in purchasing power since mid-2014 from the fall in gasoline prices.7 With continuing gains in disposable income and wealth, I expect consumer spending to grow at a solid rate. I also expect the housing sector to make further progress. Both home sales and construction have been gradually improving, and residential investment made a noticeable contribution to GDP growth over the past year. Housing has been supported by low mortgage rates, and while mortgage credit is still difficult to obtain for households with low credit scores or hard-to-document income, those with good credit histories are generally able to borrow at very favorable terms.8 And fiscal policy at the combined national, state, and local levels, which subtracted from GDP growth for much of recovery, is now a small positive.
Because personal spending is responsible for 70% of US GDP growth, a financially healthy consumer should lead to positive growth. For Yellen, the job market is the linchpin of consumer health; strong employment translates into increased consumer spending and weaker employment is followed by slower growth. The last two employment reports, which showed net establishment gains 292,000 and 255,000, should convince Yellen that the consumer will continue spending. Strong job gains lead to increased wages, which is confirmed by the 3.6% increase in the Atlanta Fed’s Wage Tracker. This, in turn, supports consumer spending, which has also been strong of late. And finally, while existing home sales have moved sideways for the last year, new home sales began an upswing in September 2015, recently hitting a post-recession high. Demand for new homes will support new building, which should reverse the residential investment contraction reported in the 1Q.
Let’s now turn to the “bad” side, which is largely comprised of weak business investment:
Business investment has been weak in the past six months or so, even beyond the energy sector, and investment in capital equipment is reported to have declined in the last quarter of 2015 and first quarter of this year. I suspect there is a transitory element to this weak investment performance, and I expect investment to rebound. But the latest labor market data raise the less favorable possibility that firms may instead have decided to expand their operations more slowly, and I intend to continue to pay close attention to developments in this area.
Yellen gave this speech before the first release of 2Q GDP, which reported an overall investment decline of 9.7%. Investment in structures, equipment and residential all decreased, the latter for the first time 9 quarters. Only intellectual property investment increased. The overall figure continues a post-oil crash pattern.
Going forward, employment market developments are key for Yellen: a strong jobs report increases the possibility of a rate cut. This would seem to indicate the latest jobs release all but guarantees a hike in the upcoming months. However, the very weak capital market numbers from the latest GDP report could point to a pause, especially considering the contraction in residential investment. But overall, I believe Yellen’s employment-first approach indicates she believes the economy is in solid shape, indicating that, barring a seriously weak economic development, she’ll argue for a rate hike in the next few meetings.