U.S. Unemployment, CPI Inflation, Stock Prices and Fed Policy

May 19, 2010

Although somewhat more upbeat about economic prospects in the United States, minutes released today from the April 28th FOMC meeting depict a hesitancy to raise interest rates soon or to sell off mortgage-backed securities before rates have begun their lift-off.  On several criteria, markets that are pricing in a one in three probability of a rate hike by the November policy meeting seems to be jumping the countdown.  These criteria are the unemployment rate, core inflation, and stock price performance.  The table below considers each of these vital signs at the start of the last four meaningful rising cycles in the Federal funds rate.  The first moves of those cycles were made on March 29, 1988, February 4, 1994, June 30, 1999 and June 30, 2004.  

To understand the table, note that the column labeled “U” gives the latest reported unemployment rate at such time.  “C” represents on-year core CPI inflation.  U-C is the difference between those rates.  Since the Fed is more likely to tighten when core inflation is high and the jobless rate is low, the inclination to tighten will be stronger when U-C is a low number.  “3M”  gives the percentage change of the Dow Jones Industrial Average over the three months prior to the first rate hike, and “6M” does the same but for the prior six months.  The final row in the table shows these values for today, May 19, 2010.

  U C U-C 3M 6M
03/29/88 5.7% 4.3% 1.4 +8.3% +9.9%
02/04/94 6.6% 2.9% 3.7 +9.5% +11.7%
06/30/99 4.2% 2.0% 2.2 +10.7% +18.3%
06/30/04 5.7% 1.7% 4.0 +0.5% +0.1%
05/19/10 9.9% 0.9% 9.0 +0.4% +1.1%


Unemployment is 3.3 percentage points higher than it was at the onset of any of the four prior rate tightening cycles.  Core CPI inflation is lower than it was before all of the earlier cycles.  Being below 1.0%, it is also less than any presumed comfort zone and doesn’t yet reflect the disinflationary impact of the dollar’s latest gains.  The U-minus-C index is 2.25 times greater than such was at the start of the last cycle and more than six times bigger than its value at the start of the earliest cycle shown in the table.  Equity prices had risen sharply prior to the first three cycles shown above.  Present circumstances surrounding stock market performance are similar now to what they were in mid-2004 with one notable difference.  The Dow’s net gains of 0.4% over the past three months and 1.1% over the past half-year mask a more recent slump that’s seen equities tumble 6.8% in the 3+ weeks since April 26th.  If this downward trend continues, equities by the autumn will be showing sizable 3- and 6-month declines.

Measured by unemployment, inflation and the first-difference between those two rates, today’s profile does not fit those that preceded rate tightening cycles in the past.  Stock markets, a barometer of investor confidence and harbinger of the willingness of consumers to spend and of businesses to invest in the future, are looking more fragile than they did when earlier tightening cycles began.  The closest facsimile occurred in 2004-06, and in fairness that’s the most relevant precedent, first because it is the most recent of the four examples and secondly because the Fed funds rate was at 1.0% then, just 75 basis points higher than now and considerably less than at the beginning of the three earlier cycles.  Officials this time will not want to wait until conditions match those of mid-2004.  It is widely felt that the Fed delayed that cycle too long.  However, the gap between that cycle and present conditions is very wide and unlikely to have narrowed enough within six months for Fed officials to feel comfortable pulling the rate tightening trigger as soon as then.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.



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