Following last week’s solid jobs report, a clear plurality of investors now expect the Federal Reserve to raise short-term interest rates next week. But once the Fed has achieved lift-off, what then? Amid ongoing dollar strength and falling energy prices, corporate profits have stagnated this year and economic growth remains pedestrian, causing concern about more of the same in 2016, but with less monetary accommodation along the way. We expect the path of Fed rate tightening to be gradual because inflation remains nearly non-existent. Even excluding food and fuel prices, so called “core inflation” also remains notably below the Fed’s 2 percent objective.
Mission Partly Accomplished
What we do have, and what is leading to the end of zero interest rate policy, is a state of relatively full employment. Although the labor force participation rate remains near decade low levels, the Fed rightfully sees its full employment mandate as having been achieved. In turn, we have seen stirrings of labor cost inflation, both statistically and anecdotally. The employment cost index is finally nearing 3 percent after having spent a prolonged stretch below that mark. Real life examples include fast food restaurants like McDonald’s and retailers Wal-Mart and TJ Maxx having to boost wage rates to keep employees; the degree to which labor inflation takes hold more broadly will be important to gauge, as this combined with the productivity of labor determine what we believe to be the single most enduring predictor of consumer price inflation – unit labor costs. Perhaps because of muted levels of capital spending later in the economic cycle, workers’ productivity has proven to be disappointing in recent quarters, increasing upward risk to this key measure. As the Yellen Fed achieves lift-off from zero percent interest rates, it will be closely tracking its labor force dashboard in helping to determine how fast and how high rates ultimately go.
OPEC finished its latest and much anticipated meeting in Austria last Friday much like we expected, acceding to the current level of the 12-member cartel’s production, but apparently not making any plans to accommodate additional liftings from Iran once UN sanctions are lifted, as expected sometime early next year. While some thought OPEC would cut production, this outcome never seemed likely. Lead producer Saudi Arabia’s strategy has come into focus – keep oil prices low enough, long enough, to accommodate its recapture of market share and stimulate enough additional demand to tighten oil markets naturally. In essence, the cartel has ceased to act as one. By all accounts, the meeting was highly contentious and unusually long, the result of discord that saw members Venezuela, Nigeria and Ecuador argue unsuccessfully for reduced liftings.
Oil prices fell on the news last Friday and have proceeded to breach late August support levels of $40/barrel. Not helping oil bulls’ cause is news this week that Iraqi production gains have boosted OPEC production to fresh three-year highs in November at the same time the El Nino weather phenomenon has warmed the Northern Hemisphere and squelched early season demand for heating oil, an important seasonal product of crude oil. These headwinds notwithstanding, we maintain our belief that oil markets will tighten as U.S. production continues to roll over, non-OPEC, ex-U.S. production stagnates, and oil demand again grows at a faster than anticipated clip. Barring a market share war within OPEC (one that would be fought with limited means given how little excess production capacity the cartel has), Saudi’s de facto strategy appears destined to succeed. We see modest levels of oversupply morphing into undersupply as 2016 progresses. After all, the following adage holds – the best cure for low oil prices is low oil prices.
Our Takeaways from the Week
- The long awaited Fed lift-off from zero interest rate policy is at hand
- Oil prices have fallen anew in the aftermath of OPEC’s highly anticipated meeting last week