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Will the Decline in Producer Prices and Hourly Earnings Delay Higher Interest Rates?

Does recent economic news point to an underlying current of slowing economic growth? Yesterday the Labor Department said U.S. producer prices recorded the sharpest fall in over 3 years by falling 0.3 percent as a result of tumbling oil prices.

Striping out volatile oil and food prices, underlying inflation is still muted. For the 12 months ending in December, the Producer Price Index is only up 1.1 percent, far below the Federal Reserve's target of 2 percent inflation.

December's unemployment report showed robust job growth with average hourly earnings falling 5 cents to $24.57. The past 12 months average hourly earnings have increased only 1.7 percent, which is slow wage growth for an unemployment rate at 5.6 percent.

Are low inflation and minimal wage growth enough to delay the Federal Reserve from increasing the federal funds rate? Markets believe the answer to that question is yes.

Markets are now betting the Fed won't increase the rate until the third quarter of 2015, later than the expected second quarter increase. The CME Group's FedWatch Tool has an implied probability of a rate hike after the Fed's October meeting. The likelihood of the hike happening after the October meeting is at 59 percent.

A more likely scenario is the Fed will increase rates sometime in the first 8 months of 2015 as a result of stronger growth. GDP growth will increase in 2015, the unemployment rate will fall, and wage growth will pickup. The main reason for this rosy forecast is low oil prices. Oil falling over 50 percent per barrel will give consumers more money to spend. Some forecasts are predicting $200 to $300 billion more spending in 2015.

Robust spending by consumers is the one piece that was missing in the economy recovery. Unleash the consumer and the U.S. will have a full-blown recovery like we last saw in the late 1990s. A higher fed funds rate will force CD rates, other deposit rates, and mortgage rates higher.
Author: Brian McKay
January 16th, 2015