The US labour market is key to understanding why the Fed wants to hike

The labour market is key to understanding why the Fed wants to hike As PCE core inflation is still subdued and below the FOMC's 2% target (1.3% y/y in October), the labour market is key to understanding why economists expect the FOMC to initiate the hiking cycle at the December meeting.

This year, non-farm payrolls have increased by 200,000 per month on average and the unemployment rate is now at 5.0%, which is within the Fed's NAIRU range. To understand why the FOMC wants to begin the tightening now, one should look at the UK, as the UK labour market is a little ahead of the US labour market.

The UK experience is that wage growth can be subdued for a long time and suddenly increase very quickly when the unemployment rate reaches the NAIRU. Wage growth in the US as measured by average hourly earnings has begun to show the same signs as illustrated in the chart to the right.

"We expect the Fed to continue tightening in the labour market, we should see increasing wage growth going forward. The increasing wage inflation means that the underlying inflation pressure in the US is increasing", says Danske Bank.

As it looks beyond temporary headwinds from lower commodity prices and the strong USD, the FOMC wants to act now as changes to monetary policy work with an approximate two- year lag. The FOMC fears that if it postpones the first hike, the hiking cycle may not be as gradual as hinted at by FOMC members, as the FOMC risks to 'fall behind the curve'.