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Fed should avoid an itchy trigger finger

We can probably all agree that the U.S. economy has not been growing like gangbusters in the first quarter of 2015. Some have tried to find a silver lining in the jobs data in recent months, but in March the nonfarm payrolls report emerged as the most lackluster indicator of all.

Despite calls for the Federal Reserve to start normalizing monetary policy by hiking interest rates this year, the data indicates maybe the Fed shouldn't be so trigger happy.

Janet Yellen
Andrew Harrer | Bloomberg | Getty Images
Janet Yellen

This week has been a real doozy for U.S. data. The personal savings rate hit multi-year highs at 5.8 percent in February, showing that Americans are not spending the savings that they are accruing at the pump. The ISM Manufacturing index reached 51.5 in February, reflecting the slowest growth in the manufacturing sector we've seen since mid-2013. The Federal Reserve's current favorite metric of inflation, core PCE (personal consumption expenditure minus oil and food) was up 0.1 percent in February compared with January, but it was down 0.1 percent on a real basis (in chained 2009 dollars).

Nothing surprised more on the downside than this morning's jobs data though. One data point does not make a trend, but looking through the headline figure for the number of jobs we've been adding in the U.S. over the past few months, I'm still hugely underwhelmed. If we continue to mainly add low-wage jobs, then we're just throwing a handful of sand into the lake and expecting a big splash.

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Most of the jobs that we are adding have been in the services sectors, where wages tend to be much lower than in goods-producing industries. As long as we are adding new low-wage jobs, there will be little upward pressure on wages. Giving workers at McDonald's owned stores, Target and TJMaxx a raise looks nice back at headquarters and helps on the margins, but is not enough to move the dial on overall wage growth across the country.

Average hourly earnings growth has been volatile over the past few months, but it is hard to see any real, sustained upward pressure on wages. There is a huge oversupply of labor globally, and this will only get worse. The current glut of labor comes from billions of workers coming online in China, but next we will have workers coming online in India and Africa. Technological developments will replace some labor as well, exacerbating this oversupply.

If there is little upward pressure on wages, it is hard to see the Fed hitting its 2-percent inflation target over the next few years. So even if unemployment is dropping like a stone in the United States, the central bank's other mandate—inflation—remains stubbornly low.

In fact, if one were to calculate inflation via the consumer price index (CPI) in the United States using the same methodology used in the European Union, prices are falling, not rising (See Figure 1). For all the panic about deflation in Europe, it turns out the U.S. isn't all that far behind.

US and Europe CPI: Same deflationary course?

Source: Bloomberg, John Hancock Asset Management, February 25 2015

Disinflationary pressures will only be exacerbated by currency moves. The Fed is considering hiking rates while almost every other major central bank is maintaining rock-bottom rates and, in some cases, purchasing private and public assets. This has pushed the U.S. dollar up significantly over the past few months relative to most other major global currencies. The United States has been effectively importing disinflationary pressures from other economies.

Federal Reserve Chairwoman Janet Yellen has made it her mantra that the timing of a policy rate hike will be data dependent. Amid weak economic indicators and no signs of inflation creeping into the system, it is hard to see the data justifying a rate hike this year.

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That being said, what policy makers should do — and what they will do — are often distinct concepts. There is significant pressure within the Federal Open Market Committee to start normalizing monetary policy, in part so that the Fed will have dry powder in its arsenal to combat any future downturns. It seems likely the Fed will hike its policy rate by a quarter percentage point towards the end of this year and then will adopt a wait-and-see approach for a number of months to gauge the impact on the economy and markets.

While the U.S.'s economic recovery has been relatively robust, the rest of the developed world has set a pretty low bar. Weak data in the first quarter of this year suggests domestic demand in the U.S. is faltering, and a strong U.S. dollar will see external demand for goods and services falter too. Let's hope the Fed's interest- rate policy really is data dependent and that the Fed doesn't give in to pressures to pull the trigger too soon.

Commentary by Megan Greene, chief economist at John Hancock.

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