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Scoring the Fed’s decision: Will it be wise to tighten in March?

U.S. Federal Reserve building in Washington.

JONATHAN ERNST/REUTERS

Now that the outcome of the U.S. Federal Reserve's next meeting has become far less certain, here's a rundown of what would have to happen for Janet Yellen and company to raise rates on March 15:

Labour markets

The Fed chair said the U.S. economy is close to a level consistent with full employment – part of the Fed's dual mandate – but a number of labour-market indicators have taken a step back recently. Foremost among them: average hourly earnings, the employment cost index and the Atlanta Fed's wage-growth tracker.

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The Fed will get three more readings on jobless claims after data Wednesday added to labour-market bullishness. But the central bank will likely need to see an strong rise in wage growth in the March 3 jobs report for it to lean toward hiking.

Inflation

Containing price growth is the other part of the Fed's mandate, but it's spent the better part of the bull market trying to boost inflation back toward a 2 per cent target. Ms. Yellen signalled she's ready to play inflation cop again, but several measures will need to show improvement in coming weeks.

Core personal-consumption expenditure, or core PCE, has been below the Fed target since 2012, and recent monthly readings point to a slowdown in the bank's preferred gauge of annual inflation. If that trend continues, March becomes less likely.

Other inflation measures have shown a healthier picture, with the consumer price index accelerating to 2.5 per cent last month, and survey and market-based gauges of expectations turning more bullish to approach the Fed goal.

Analysts warn, though, that the details of the CPI report aren't as strong as the headline figure, while the Fed itself said two weeks ago that break-evens remained too low to warrant tightening. Will another month at current levels influence policy makers?

The next PCE report is due March 1, while the CPI data won't get an update until the morning of the Fed's announcement.

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Fiscal policy

In December, the promise of pro-growth policies from the Trump administration helped move the number of rate hikes deemed appropriate for 2017 to three from two – improving the odds for a March hike.

Since then, the White House has provided scant details on planned spending increases and tax cuts, while focusing instead on protectionist trade and immigration policies that could weigh on growth. The Fed has no choice but to wait for policy proposals before changing its estimates, Ms. Yellen said. "We are not basing our judgments about current interest rates on speculation" about fiscal policy, she said.

That leaves the Fed ostensibly beholden to measures on economic strength, which have been improving lately. Retail sales surged, prices are rising and housing starts topped estimates. Further improvements will test the bank's resolve, even if Donald Trump fails to deliver on his policy prescriptions.

Business investment

One of the Fed's favoured indicators for future economic growth is capital spending, a measure that the central bank said "remains soft." Business confidence has surged since then, with indexes compiled by Morgan Stanley and Renaissance Macro Research affirming the improvement.

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January's durable-goods orders will be the most concrete update that officials get. Regional Fed surveys as well as anecdotes compiled in the Beige Book will also provide a better idea of whether a surge in capital spending is poised to kick off the next phase of expansion.

Financial markets

Major equity indexes near all-time highs and tightening credit spreads paint a rosy growth outlook and bolster the argument for tightening, but that's somewhat offset by the rise in Treasury yields, which imply higher borrowing costs that may weigh on activity.

Those indicators likely pale in influence compared with the U.S. dollar, at least for the Fed. The greenback is down this year, implying a smaller drag from net exports.

However, the lagged effects of its rise over the past two-and-a-half years will encourage imports and discourage shipments abroad in the short term.

Markets will surely factor into the decision, but with a mixed picture across assets, the Fed likely won't get a clear signal for its coming meeting.

International developments

One of the causes of the aforementioned rise in bond yields? A widespread firming in global growth, and that's good news for rate bulls. Signs that this momentum is not fleeting would only add to the case.

The drag from China that helped delay liftoff in 2015 has abated to the point of becoming a tailwind, as signs emerge of higher prices and stronger growth in the world's second-largest economy.

"Global financial markets seem to have bought into the notion that China-related risks will be managed, shrugging off China's significant bond and foreign-exchange market volatility in recent months," write Goldman Sachs Group Inc. economists led by Andrew Tilton.

European growth is also showing signs of improvement, but perhaps more than in recent years, geopolitical concerns loom just as large. Brexit is proceeding apace, the Dutch look poised to elect next month a Euroskeptic and French polling data suggest an anti-European candidate is rising – with any of the three events capable of upending socioeconomic norms that could give the Fed reason to stand pat.

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About the Author
Investing reporter

Luke Kawa joined the Globe and Mail as an investing reporter in 2014. He is a graduate of St. John’s University with a B.S. in Economics. Previously, he was the editor of Business in Canada and a contributor to Maclean’s. He has also written for Business Insider’s Money Game and Clusterstock verticals. More

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