The May US employment report changes the landscape for the Fed

Following ambiguous results last month, which everyone could read as he or she wanted, the May US employment report at least clarifies the situation. Not only was job creation more vigorous, but the rise in wages confirmed the trend toward a normalized Phillips curve. In this case, the Fed theoretically has little choice; it must change tack. Forthcoming inflation figures, boosted by oil prices, will make such a change all the more natural, especially as economic activity is strengthening.

Notwithstanding the uncertainties and caution that current trade tensions have aroused, Fed Chairman Jerome Powell would now seem to have little scope for retrenchment. In other words, the May employment report may well constitute a change in the monetary landscape, with in all likelihood, significant consequences for the market.

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The oil threat

The increased tension surrounding Syria caused the oil price to surge beyond $72 per barrel last week, and there is a significant risk of escalation that could drive prices much higher than their current levels, at least temporarily. This scenario is worrying in many respects.

Movements in oil prices have been key movers of the global economy and financial markets for the last four years, and have usually exacerbated any existing fragilities. Their collapse in 2014 was partly responsible for the increase in deflationary pressure and the subsequent monetary response from the ECB and BoJ. Then, the rebound from their January 2016 low deprived consumers of what little increase in real incomes they had seen in 2015, but without being sufficient to drive any real improvement in the situation of emerging-market exporters, which were also seeing increasing competition from the USA. The run-up in prices over the last few days could be more effective in this respect, unless, on the contrary, it sparks a crisis by causing more pain for consumers while also triggering an excessively radical jump in interest rates, which could happen quickly given the barely concealed impatience of central bank officials to escape from today’s low-interest-rate situation. That combination clearly does not bode well, since it could quickly turn into a major threat for global growth and the financial markets.

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Central bankers caught between the Scylla of inequalities and the Charybdis of financial bubbles

Monetary policies have traditionally not been concerned with the subject of inequality, even when their role has been to help the economy achieve full employment. Rather, policymakers have generally limited themselves to a macroeconomic approach guided by statistics such as aggregate growth, inflation, unemployment rates and average wage rates. But in recent years, the subject has made its way onto the agenda of a growing number of central bankers.

Former Fed Chairwoman Janet Yellen set this change in motion and seems to have attracted a certain number of monetary policy followers. In the United States, Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, has often voiced his support of this approach. In January 2017, with Ms. Yellen’s support, he even went so far as to create the “Opportunity and Inclusive Growth Institute”, whose mission is to promote research that “will increase economic opportunity and inclusive growth and help the Federal Reserve achieve its maximum employment mandate”.

In Europe, the topic has become an important factor in Mario Draghi’s adjustments to monetary policy over the last two years. As Janet Yellen began to do in January 2014 by developing a series of complementary unemployment indicators, so the ECB chairman has regularly made reference to labor market slack and called attention to the risk of relying solely on the unemployment rate, which has become less and less representative of economic reality. He regularly speaks of underemployment, forced part-time work and multiple jobs to justify the continuation of hyper-accommodative monetary policy despite clearly improved economic conditions in the euro zone since the start of last year.

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So the era of low interest rates will soon be over, right?

Trends in the financial markets have accelerated in the last few days. After hesitating slightly at the start of 2018, it is increasingly obvious to investors that reflation is around the corner. That belief is based on widespread growth, a surging oil price, the first positive effects of Donald Trump’s tax reform – with giant US companies promising to repatriate profits – and good news on investment and jobs. It is hard to see how that situation could fail to end the phase of latent deflation in the last few years and support expectations – seen throughout 2017 – of inflation getting back to normal. The impact of rising oil prices alone could significantly change the inflation situation, judging by how sensitive inflation is to movements in oil prices. If crude stabilises at $70 per barrel between now and the summer, inflation could rise by more than half a point in the industrialised world, taking it well above the 2% target that it touched only briefly in February 2017.

So what could prevent a significant increase in interest rates? It is very tempting to change our outlook for 2018. How is the interest-rate environment likely to develop?

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