The Fed Looks to Stay Frozen

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Friday's great payroll and wage numbers–the economy added a better-than-expected 167,000 jobs last month as earnings rose 0.5 percent–marked a real blow to the "hard landing" economic scenario that sees the economy slowing to near-recession levels because of the housing downturn. As long as this economy keeps creating jobs and boosting wages, consumers are likely to continue spending, thus keeping the economy rolling. It's a virtuous circle, so to speak, that makes it unlikely that the Federal Reserve–on ice since last June–will feel the need to cut interest rates anytime soon. As a research note from Action Economics puts it:

The "hard landing scenario," which envisions that the housing market correction of the last 16 months is prompting large "contagion" effects on the other sectors of the economy that will pull down GDP growth by more than the modest amount indicated by the "direct" housing sector impact, is notably failing to materialize. Today's jobs report makes this scenario particularly hard to still justify, hence reducing the likely significance of these fears at the Fed.

More and more, I've come to think that the Fed is going to be stuck in neutral for a while, not raising short-term interest rates either. Here's why:

1) Futures traders aren't expecting a move. One way to predict what the Fed will do is by looking at the action of the 30-day Fed funds futures contract that is traded at the Chicago Board of Trade. As calculated by the Federal Reserve Bank of Cleveland using the contract's trading performance, there's about a 60 percent chance that the short-term rate will still be sitting at 5.25 percent after the May Fed meeting.

2) Inflation expectations aren't rising. Long-term inflation expectations can be gauged by looking at the difference between yields on 10-year U.S. treasury bonds and 10-year treasury inflation protected securities, or TIPS. That difference represents what investors think inflation will be over the next decade. As calculated, again by the Cleveland Fed, 10-year inflation expectations are currently 2.28 percent, down from 2.66 percent in May. Although the Fed would prefer to have inflation expectations in the 1 to 2 percent range, the trend is in the right direction. And, actually, once the Cleveland Fed adjusts for various statistical biases in the measures, its calculations peg current long-term inflation expectations at 1.99 percent, just inside the Fed's comfort level.

So given all that, plus the fact that oil prices are down 25 percent from their high and recent consumer and producer price numbers show inflation pressures receding, it seems a safe bet that the Fed will be stuck on pause for some time.