Where the Fed goes from here

What does weaker-than-expected March jobs growth mean for the path of rate normalization? Rick Rieder weighs in.

A variety of weather-related factors resulted in modestly slower-than-expected U.S. jobs growth in March. You may now be wondering: What does this report mean for the Federal Reserve’s (Fed’s) path from here?

We don’t believe the March jobs report takes the Fed off its tightening path. We still see the central bank raising interest rates three to four times over the next year.

The top-line March payroll number surprised to the downside, but last month’s jobs report overall was solid, reinforcing that the U.S. economy is reflating and growing at a nice clip. This year’s three-month, six-month and 12-month payroll gains moving averages of 178,000, 163,000, and 182,000, respectively, show the labor market is off to a remarkably strong start in 2017.

The unemployment rate ticked down to 4.5%, and we think continued labor market strength will allow the rate to march toward the low-4% region by year-end. Meanwhile, wages grew moderately in March, with average hourly earnings up 2.7% year-over-year, suggesting durable wage acceleration. Over time, we expect labor market tightness will place upward pressure on wages, and there are indications that recent wage growth also appears to be taking hold in the lower- and middle-income job categories, areas most in need of it.

Against this backdrop, the Fed is likely to raise rates three to four more times over the next year, even though we’re already three rate hikes into the current hiking cycle. The Fed raised policy rate levels by a quarter point at its mid-March meeting, and the U.S. economy has achieved sufficient levels of unemployment and inflation to encourage further gradual policy tightening this year and into next. Also supporting further rate normalization: Absolute levels of interest rates are still so low that financial conditions are actually quite accommodative.

It is possible that the Fed could limit the number of times it raises interest rates to three this year, while simultaneously moderately reducing the size of its balance sheet later this year. New York Fed President William Dudley recently suggested that balance sheet normalization could stand as a substitute for policy rate normalization, a view that if adopted by the Federal Open Market Committee could alter the market-expected trajectory of rate normalization. Additionally, Trump administration appointments to the Fed’s Board of Governors could also impact the outcomes of rate normalization and balance sheet adjustment, so we’ll be watching this nomination process very carefully.

The timing of the hikes will matter a lot for the trajectory of interest rates, though rates are likely to remain relatively low from a historical perspective, and may even go a bit lower, over the short term. We believe short-end rates will rise, but there are factors that will likely keep U.S. long-end rates contained. The European Central Bank will likely continue to be very slow in moving rates higher in Europe given the region’s sluggish economic growth along with uncertainty surrounding elections in the coming months. Other factors likely keeping long-end rates low in the near term include the challenging legislative process in the U.S. and the recent escalation of geopolitical events out of Washington.

Investing in this kind of rate environment can be challenging, and this is why we advocate considering a flexible and diversified fixed income approach that looks for opportunities across a wide set of strategies, asset classes and markets.

Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income and is a regular contributor to The Blog.

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