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By Robert Johnson, CFA and Jeremy Glaser | 07-27-2016 01:00 PM

Jobs Still Key to Fed Rate Decision

With headline inflation likely to remain tame, Morningstar's Bob Johnson thinks strong jobs data will be needed to force the Fed's hand in September.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. As expected, the Fed didn't raise rates at their latest meeting, but is the door open for a September hike? I'm here with Bob Johnson for the answer. Bob, thanks for joining me.

Bob Johnson: Great to be here today.

Glaser: So let's talk about the statement. You said not a whole lot changed from July, from the previous month.

Johnson: No. Usually, I have to spend some time figuring out where the red lines, and what the new things inserted were, and there really wasn't much of that this time at all. They changed the words around the labor market, and said it was strengthening. One of the Fed governors voted for rate increase, so that was one of the changes that was unanimous the last time. This time, this person's name is crossed out, added as a new name in the disagree pile. And so there really weren't many changes in the document at all. No further hints about timing whatsoever, other than at the back end where they say they're data driven; which stayed as it was in the previous one, and they said labor is stronger and risks are diminished. So some people are reading that that maybe September's on the table again. We'll have to see.

Glaser: So what do you think that they would need to see between now and September to push them over the edge?

Johnson: Well, I think you'd have to see another very strong month of labor force growth. And recall that we had one really poor month that scared them off in May, then had a really great month in June. Now, if we have another really great month in July and August, then it will force their hand at the September meeting, I think, if the labor market really strongly continues to tighten. I think some of the inflation reports will be important as well, if inflation gets out of hand. They already know that service is a little bit out of hand, but they're willing to live with that and take the risk. But if the headline CPI number starts getting out of hand in total, I think they would also potentially panic as early as September. But, hey, given goods prices have been down a little bit recently, we've seen the oil prices continue to erode a bit, they may have bought themselves a little bit more time, yet again. They always say they watch Core but on the other hand if they figure, "Well, the headline is really low and the average consumer thinks that it's really low, maybe we don't have to do anything just yet."

Glaser: Looking at that goods number, what do you think could turn that inflation around? Where could we start to see goods inflation? Is it just that's been held up by a strong dollar, by weak demand? What do you think is, what are the drivers there?

Johnson: Well it's a real combination of all the above, but certainly, one of the ones really hitting now is that the certainly gasoline prices are back down again and they've fallen. They had a pretty strong rise for the three spring months. And now, we're kind of back down again. Seasonally, that's a little bit of the pattern, but even seasonally adjusted, gasoline prices have fallen quite a bit again, and as has the price of a barrel of oil after the Brexit situation. So that will keep anything that's energy related goods down, and the dollar has wavered a little bit in here, but it's generally been stronger after Brexit; and again, that makes our imports cheaper, and that keeps the lid on goods. And the other big thing that drives things and what's happening with food prices, and, again, that's always kind of, well, how's the weather? Do we have a hailstorm? Do we have a major drought or something? And again, none of those appear on the horizon right now, so that will keep the food inflation as an additional item to keep the lid on things.

So again, in auto prices, because of difficulties they've had on moving inventory, are also likely to not move up and that's another key goods category. So we just don't see it on the good side of the equation. In fact, it's gonna depress the thing and offset some of the services inflation that we've been talking about for so long.

Glaser: So you look at something like the durable goods report that was out this week, that doesn't give you any pause that maybe we're gonna see that goods inflation.

Johnson: No. The report was actually a little bit poorer than I anticipated. Durable good orders excluding transportation; which is the big Boeing orders and so forth, were down about 0.5 of a percent month to month. And that followed a month of being down 0.4 of a percent. So clearly, manufacturing, despite some better news on industrial production a couple of weeks ago, and better news out of the various purchasing manager surveys, the orders just didn't come through. And again, that would suggest weak demand and weak demand suggests that maybe we won't see so much inflation on the goods side; the durable goods side. And certainly, the durable goods report's become a little tricky. It's like the retail sales report now. This one's not inflation-adjusted. And in the past, a lot of the durable goods, more of the factory-oriented stuff really didn't move very much, so I didn't have to worry about it, whereas a lot of consumer goods moved a lot. You needed to adjust for it. And this time around in durable goods certainly we have seen some rough numbers but maybe some of that is price.

Glaser: So overall, it seems like they could raise rates in September but it's really gonna depend on what happens with the labor market.

Johnson: I think it's really gonna depend on the labor market and again, if anything bad happens relative to Brexit--Brexit's kind of gone away as an issue for now. Nobody was ever really very worried about the direct impact because they're a relatively small economy in the U.K., but everybody who was worried about the psychological and sentiment type surveys and now that the markets are back up, well, nothing's happening, so everybody's taking a pause. Now, if we had a flaw in the negotiations, or anybody starts calling names to anybody else, well then, that's back on the table again.

Glaser: Bob, thank you for your analysis of the statements today.

Johnson: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser, thanks for watching.

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