US: robust expansion and the start of interest rate hikes?

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September 9th, 2015

The continued improvement in the US labour market and significant growth in its economy have revived debate as to whether now is the right time for the Federal Reserve (Fed) to start its interest rate hikes and how quickly these should rise. This question is crucial because, if the US GDP is almost back on track in terms of its growth potential, any delay by the Fed in raising its reference rate could lead to inflationary pressures, certain asset bubbles and, ultimately, excessive debt levels.

Gauging whether the US economy is now approaching its potential GDP, or if it is about to close its output gap after years of a negative gap, is vital in order to determine the direction the Fed should take.1 However, it seems that the margin for error in estimating this theoretical variable has increased considerably over the last few years, making this task a difficult one. By way of example, the nominal interest rate resulting from the classic Taylor rule varies substantially (by 2 pps) depending on whether we use the potential GDP for the US estimated by the IMF in its World Economic Outlook (WEO) of April 2014 or April 2015. According to the estimate in April 2014, the Fed's current ultra-accommodative policy is more than justified, unlike what happens if we apply the estimate from April 2015.

Given that such traditional measures to determine the output gap are nowadays less effective, more direct but partial measures are now being used such as indicators for labour market activity. This discussion of the appropriateness of starting interest rate hikes would have seemed odd from the perspective of just three years ago given that unemployment currently stands at 5.3%, a figure far below the 6.5% guideline set by the Fed at that time to start raising interest rates. This target was already dismissed in March 2014 when unemployment was close to 6.5% and core inflation significantly below the 2% set by the institution.

At present, with inflation still low and moderate wage rises moderate, the opinion that hikes should be postponed is getting a lot of support. Specifically, wages are growing at around 2% year-on-year, far from what Janet Yellen, President of the Fed, considers to be the zone of «normality» (between 3% and 4%). Similarly, the improvement seen in the labour market is less clear when we look at broader unemployment measures rather than the simple unemployment rate, as these also take into account workers who are discouraged or working part-time involuntarily.

However, the strong upswing seen in the number of job vacancies in the last few quarters and the growing difficulty in filling them indicate that the simple unemployment rate is an increasingly reliable measure of vitality in the labour market. July's 5.3% unemployment rate would therefore suggest that interest rate hikes should not be delayed. Similarly, although still showing subdued increases, wages are starting to show signs of accelerating, rising by 2.7% in annualised terms since the beginning of the year.

In short, although there are still doubts regarding exactly how far the US economy currently stands from its potential GDP, numerous activity indicators suggest it is close enough. The Fed might be sensitive to global financial volatility, falling commodity prices and the dollar's appreciation but the robustness of the US recovery would justify the start of interest rate normalisation.

1. Potential GDP is a theoretical variable defined as the level of production compatible with stable core inflation around its target level. For more information on this concept, see the Dossier in MR05/2013 («Potential GDP, a key but unclear concept»).