Strong Jobs Report Boosts Federal Reserve Confidence

For months the Federal Reserve has insisted it is more concerned about inflation than growth, but after last Friday’s employment report, investors may finally take this claim seriously.

The jobs report - which showed a decline in unemployment to 4.4 percent in March - will boost the Fed’s confidence that consumer demand will keep the economy moving forward at a “moderate pace” of roughly 2 percent growth in spite of difficulties in the housing market.

At the same time, the jobs report underscores risks to the Fed’s baseline forecast that inflation will “moderate over time.” Small wonder that U.S. bond prices sold off sharply on Friday, pushing 10-year yields up to 4.75 per cent.

With core inflation back up to 2.4 percent year over year, and purchasing manager surveys picking up heightened price pressure, the U.S. central bank was already feeling uncomfortable on the inflation front.

Behind this mix of subpar economic growth, sticky inflation and strong jobs generation is surprisingly weak productivity growth, which may have both cyclical and structural elements.

This factor complicates more than just the volume of mortgage applications - it impacts the Fed’s job of balancing the risks to growth and inflation.

The jobs report will by no means eliminate all concern about growth. The Fed knows that unemployment could be a lagging indicator, although it may not lag behind growth as much as it did in the past.

Looking ahead, there remain big risks to growth from the housing market -which has been under additional pressure due to a meltdown in the subprime [bad credit mortgage] market - and weak business investment, which baffles Fed policymakers.

Consumer spending could flag in the months ahead as higher energy prices eat into disposable income, particularly if corporate caution results in slower hiring or if widely publicised housing woes depress confidence.

Looking forward, there are also serious reasons to worry that inflation may not fall as the Fed wants it to. The recent move up in the price of oil means the U.S. will no longer benefit from lower oil prices.

Inflation expectations have not fallen as the Fed hoped they would, and on some measures have edged higher since the start of the year.

The Fed is relying heavily on moderating rents (and proxy rents, which are used to estimate the cost of owner-occupied housing) to lower inflation.

But the Fed could be in for a long wait. As home mortgage costs continue to keep buyers out of the market - and renting units - recent figures show no sign of a downward break in rent trends.

These factors explain why the Fed thinks that, while risks to both growth and inflation have risen since the start of 2007, inflation remains the “predominant policy concern.”

This does not mean there is any short-term risk of rate increases.

While the housing adjustment continues, growth remains significantly below trend (seen as between 2.75 and 3 percent) and there is serious danger of further weakness, the Fed will be patient.

Investors have already done some anti-inflationary work by raising longer-term interest rates in the bond market on Friday. The Fed can tighten the monetary conditions further, if it needs to, by simply not cutting rates as the market still expects later this year.

Yet Fed policymakers looking ahead to the year-end ponder what might happen if inflation remains sticky, the jobs market remains as tight as it is at the moment, business investment comes back and the drag from the housing market peters out.

In that scenario - still only hypothetical - home loan rate rises would become a genuine possibility again.

Even if unemployment does begin to edge up from here, the Fed is unlikely to move swiftly to consider rate cuts - as the market seems to expect -unless there are other compelling reasons to do so.

A limited rise in unemployment would be seen by many policymakers as a sign that the risks to both inflation and growth were moderating, strengthening the case for interest rates (and thus, mortgage rates) to remain on hold.

SOURCE: MSNBC