Sunday, May 24, 2015

The Fed’s Labor Question

Print FriendlyEditor’s Note: With 2014 rapidly approaching, I wish all of our readers a safe and prosperous New Year!

Since the Federal Reserve decided to begin tapering its asset purchases last week, more data has come out bolstering its decision. In particular, the US Commerce Department released revised third quarter US gross domestic product (GDP) figures that showed even stronger growth than previously estimated.

When the unrevised data was initially released, it showed year-over-year growth of just 2.85 percent in the quarter, but that was quickly revised upward to 4.13 percent. Higher-than-estimated consumer spending, which the Commerce Department now says grew at a 2 percent annual rate over the summer, drove much of that upward revision.

Business spending, as measured by nonresidential fixed investment, also played a major role and was revised upward by more than 100 basis points, from 3.5 percent to a 4.8 percent annual rate.

Viewed through that lens, the Fed’s decision to slow its monthly bond purchases by just $10 billion might seem a bit too conservative, particularly since the unemployment rate is falling and the Fed’s measure of inflation is well within its comfort zone.

One of the reasons the Fed didn’t play its taper hand too aggressively was its desire to avoid the sell-off we saw when it just hinted at cutting its purchases earlier in the summer. But as the case has been for more than three years now, the labor force remains the problem.

While the US unemployment rate is falling towards 7 percent and is well off its nearly 10 percent high of late 2009, as you can see from the graph below a major reason unemployment has been falling is that workers have simply been dropping out of the labor force.

Only about 63 percent of those who could be participating in the US labor market actually are, the lowest level in more than two decades. When they&rsquo! ;re no longer seeking work, they no longer count as one of the unemployed.

The Fed is now betting that the low participation rate is largely due to cyclical factors—i.e., the economy simply isn’t growing fast enough to create sufficient jobs to lure back these discouraged workers. By that line of reasoning, the Fed could keep its monetary policy easy for an extended period of time since growth with high unemployment means no upward pressure on wages. That keeps inflation low and, under the Fed’s dual mandate, justifies continuing an accommodative policy.

But what if the drop off in labor force participation is structural, rather than cyclical? What if workers are choosing to remain outside of the labor forced for other, longer-lasting reasons?

If that’s the case, the Fed might have a problem.

When the economy is growing and creating jobs, yet workers still choose not to participate in the labor force, the unemployment rate will drop even faster. At the same time, as the labor market tightens, employers will be forced to offer higher wages to attract the workers they need.

While wages aren’t growing nearly as quickly as they were before the Great Recession, as you can see from the graph below, they have been steadily ticking up over the past two years, even as the labor force participation rate has been falling.

Evidence shows that workers haven’t routinely been receiving cost-of-living increases. For example, federal employees—who have some of the strongest unions in the US—haven’t had a pay hike in three years. They’re only receiving a 1 percent pay increase next year because it was part of the deal crafted to end October’s government shutdown.

That’s a good indication that potential employers are offering hi! gher wage! s to lure workers back into jobs, even as the labor force remains extremely slack. The upshot is that the low labor force participation rate is likely more structural than cyclical, leaving the Fed in a conundrum.

If the problem is indeed structural, any move by the Fed to substantially curb quantitative easing would have stalled the economy. However, an increase in the pace of wage growth would stoke inflation.

Consequently, even if the Fed continues to taper, it will be forced to hold down interest rates well into 2015.

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