On Wednesday 14 June, the Fed decided to raise the official interest rate in the United States for the second time this year. The interest rate is currently at 1,25 percent. The bank also said it has plans to raise interest rates again this year.
The Fed also wants to increase interest rates 2018 times a year in 2019 and 3. However, it remains to be seen whether things will progress at such a pace.
The Phillips curve
The reason for the Fed to raise rates and not to change plans for future interest rates is confidence in an old, statistically established relationship that economists call the Phillips curve. That curve says that a tight labor market causes inflation, because when labor becomes scarce, its price (wages) rise. This means that companies see their production costs rise and pass them on to the end customer. This causes rising inflation.
The problem is that the US labor market, with an unemployment rate of 4,3 percent, has seemed quite tight for some time (4,6 percent is the border between a normal and tight labor market). However, inflation has fallen significantly recently. The monetary devaluation was still 2,7 percent in February, but this has now fallen to 1,9 percent. That is a bit too low for the Fed.
The above means that the unemployment rate in the US is incorrect (unemployment is actually higher than what the statistics show) or the said relationship is not as strong today as it used to be. There is something to be said for both options.
Hidden unemployment
There are many Americans who are actually unemployed, but are not counted as such. That's because of the definition of the word "unemployed." You must be immediately available for work, be able to work more than 12 hours a week and have applied frequently in recent weeks. In addition, there are people who have a part-time job, but would actually like to work full-time.
If we were to include those "hidden" figures, the actual unemployment would be around 10 percent. It is therefore not surprising that inflation pressure from the labor market is barely noticeable.
On the other hand, it would not be surprising if the Phillips curve is no longer as strong as it used to be. Globalization may have significantly distorted the relationship between unemployment and inflation. The fact that many jobs in the US have low wages also fits in well with this. The combination of low wages and high unemployment means that wages do not have to rise further. After all, anyone who asks for more money can easily be replaced.
Nowadays, low unemployment does not necessarily have to lead to wage increases. This is because employees know that if labor becomes too expensive, jobs can be moved to other locations in the world. This constant danger ensures that wage demands are moderated.
Question marks
Whatever the explanation, it certainly calls into question the Fed's promise to raise rates again this year. And to repeat that 2018 more times in 3.
If it becomes clear that unemployment is much higher, this would mean, on the one hand, that the economy is in less good shape and, on the other hand, that inflation pressure will not materialize for the time being. New interest rate increases are not appropriate in such an environment.
If wages do not rise faster in the coming months, while unemployment remains low or falls further, confidence in the "low unemployment means rising inflation" relationship within the Fed may well crumble. Especially when the Fed gets a new chairman. Janet Yellen (current chairman) is a labor economist and a firm believer in the Phillips curve. Interest rate increases would also be strange in this scenario.
The market indeed has its doubts. Although the Fed has underlined that it will raise rates again this year, the market sees that chance as less than 50 percent. In the near future it should become clear who is right.
Interest rates under pressure
All this could put downward pressure on US interest rates in the coming months. The dollar may also become weaker (EUR/USD will then come under upward pressure). The latter will not take extreme forms, because there are no reasons from the eurozone for a stronger euro.
De European Central Bank is keeping its interest rate policy very loose for the time being and new problems, for example with Greece or Italy, could easily arise again. Low interest rates in the eurozone with a slightly stronger euro could become the summer scenario on the European markets.