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THE LUMBER MARKET: Rate Hikes and the Recovery

Another measure of labor force slack that the Fed watches is wage growth.

Despite the dramatic drop in unemployment since 2008, wage growth has remained near 2% per year. Historically, wage growth picks up as unemployment rates decline, with about a 12-18-month lag. Wages have not accelerated despite a drop in unemployment from 10% to 6%. This confirms that there is more slack in the labor market than the unemployment rate suggests.

The lack of wage rate improvement has also created another serious issue that is affecting both the overall economy and housing starts. As addressed in last month’s spotlight, there is a serious income distribution issue in the country. Labor’s share of overall GDP historically averaged 63-65% and is a key driver of consumption expenditure. That share has plummeted in recent years. There are a number of explanations being put forth, but we won’t tackle that issue here. The lack of wage growth and the sluggish rebound in consumption expenditures, however, supports the case of some policy makers that unemployment rates should be allowed to fall further in order to boost wages.

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Inflation, which has been the other target of the Fed, has also remained very subdued. Inflation is currently still near or below 2%. The FEA forecast for inflation calls for a modest run-up in inflation over the next few years. This is very close to what members of the Fed’s Open Market Committee believe as well.

Forward Guidance: When Will Interest Rates Start to Rise?

In September, the financial press was expecting the Fed to make changes to its forward guidance message. To comfort bondholders (who fear that a repeat of 2013 will happen when the Fed acts) the Fed’s guidance was clear: there would not be an increase short-term interest rates for a “considerable period.” Several articles in the Wall Street Journal (WSJ) suggested those two words might be deleted at the September meeting. The language was NOT changed.

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Despite an unemployment rate now below 6%, Chairman Yellen appears to be following Chairman Bernanke and would prefer to act slowly to ensure that the economic recovery is solid. To further calm the bond markets, Chairman Yellen has made it clear that the interest rate hikes will be moderate after the actions begin. Most monetary analysts interpret this as 0.25% hikes every meeting or 1.5% over the first year.

Bottom Line: Rate Hikes Won’t Kill Recovery Until After 2017

A variety of public statements and a range of concerns about the health of the recovery suggest the Fed will be very cautious and err on being late in taking away the “Punch Bowl.” There have been a number of assurances in speeches by Chairman Yellen that the Fed will act properly when the economic recovery builds momentum. Given the tremendous liquidity in the financial system and no indication that the Fed will take any action to “drain” them over the next year, there is more upside growth potential over the next few years than downside. Since there is a long and variable lag to any actions the Fed takes, economic growth should continue through 2017 and perhaps through 2018.

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