- Besides the unemployment rate and the change in nonfarm payrolls, the Fed has moved to a broader set of indicators to assess labour market slack. The former suggest that the slack in the labour market is quickly fading, but the latter suggest that the progress has been more limited.
- Interpreting labour market slack has become the core business of the Fed. We think that over the coming three quarters the labour market will reach its full potential. This means that the Fed will likely start raising interest rates by the middle of next year.
What are the main stream views on the labour market?
One of the most interesting topics in the US policy debate is the health of the labour market and what that means for monetary policy. There is uncertainty about when and how fast to raise interest rates to meet the Fed’s dual goal of employment and price stability. On the one hand, the so called “doves” suggest that US unemployment is still largely cyclical, resulting from the slowdown in economic activity. These economists think that it is too soon to tighten monetary policy, since the labour market has still to recover from the global recession. For these economists, it may even be acceptable to have some inflation in the process of strengthening the labour market, since the costs of higher inflation will be lower than unemployment costs. On the other hand, there are the “hawks” that think that the labour market is close to its potential and the natural rate of unemployment is higher than before the global financial crisis. This rate of unemployment is the result of mismatches between supply and demand of workers, demographic trends and other factors that prevent the labour market from clearing and are therefore the cause of structural unemployment. The fear is that an already tight labour market might soon trigger wage and inflation pressures.
What are the FOMC positions in this debate?
The Fed has a dual mandate to foster full employment and price stability. Currently the long-term unemployment target is in the order of 5.2%-5.5% and the long-term inflation objective is at 2%. Any discussion on the labour market is framed on the basis of this mandate. For the past few years, the Fed has been confronted with considerable slack in the labour market and the threat that inflation remains below target. Very loos monetary policy was thus justified. But now that the economy is getting closer to its two objectives, there is uncertainty within the Federal Open Market Committee (FOMC) on the trajectory of the recovery and the timing for the first rate hike. On the one hand, July’s FOMC statement mentioned that “a range of labour market indicators suggest that there remains a significant underutilisation of labour resources”. On the other hand, in the minutes it became clear that some of the FOMC members judge that the progress already achieved in the labour market is “sufficient to warrant a change in policy”. However, when voting during July’s meeting, most members of the Committee continued to support keeping low rates, or “below what is considered normal”. Since then we sense that even some dovish members, who tend to have more influence on the direction of the Fed’s decisions are lately showing a more balanced tone (Yellen and Fischer), suggesting they put more weight than before on structural impediments to the labour market. Because of the uncertainty on how the job market will play out in the months ahead, Fed officials will at some point stop offering assurance that the Fed will wait a “considerable time” for the rate hike. However dropping this term could have a meaningful impact on markets since in the past such a move has come with a rate hike in the following six months. We think that it is too early to drop the term. Fed officials across the spectrum have argued that this term has to be dropped sooner or later.
How does the Fed assess the labour market?
In the FOMC minutes, the unemployment rate, payroll employment and initial jobless claims are the most often-cited labour market indicators. Although a few FOMC members argue that the unemployment rate is a reliable indicator of the overall state of the labour market, many members are not in favour of using a single indicator to capture the level of slack the labour market. Alternative measures of slack provide additional information on the labour market momentum beyond that contained in the nonfarm payrolls or unemployment rate. These include the labour force participation rate and indicators that focus on the flows of the labour market from the Job Openings and Labor Turnover Survey (JOLTS), such as the pace of hires, quits, job openings and lay-offs. Indeed, the Chair of the Fed considers payrolls and the unemployment rate as the primary indicators, but has endorsed a dashboard approach for looking at the labour market. The indicators above provide basic information on the trends since the Global Recession and also a longer term trend of the past 15 years.
Is more data on the labour market better?
There is not one indicator that tells the whole story. Indeed, a holistic approach can better portray the conditions in the labour market. This is one of the reasons why the FOMC routinely reviews a wide variety of indicators. At the same time, it is interesting to look at individual markets, given that particular markets could be tighter than others and some are also leading others. For instance, professional services are often considered important leading indicators of the labour market as a whole. Currently average hourly earnings in this market are 2.4% yoy compared to the 2.1% average hourly earnings of all employees. Moreover, focusing on one report can be misleading as specific reports are often influenced by special factors.
What are these indicators saying about the health of the labour market?
A number of indicators are showing a strengthening of the US labour market. The unemployment rate decline of 1.1 percentage points in the past year is the fastest in nearly 30 years. Job growth has also strengthened over the course of this year with 1.5 million jobs added so far this year. This is the best outcome since 1999. This positive trend has forced the Fed to adjust downward the unemployment forecasts. In 2012 the Fed’s mid-point forecast for unemployment in 2014 was 7.4% and now it is 6.1%.
There are, however, other indicators that are showing a more mixed picture. For instance, data that measures the flows in the labour market, such as the quits and the hiring rates, has shown a somewhat modest growth pattern. One explanation for a low quits rate is that employees may still find it too early in the job market recovery to leave their jobs and search for better opportunities, while subdued hiring, despite lower unemployment could be an indication that firms are having difficulty in finding the right qualified applicants for the vacancies. One of the consequences of this combination of modest hiring and a depressed quits rate, is suppressed wage growth. Workers usually negotiate higher wages when they are moving to other jobs. Indeed, wage growth is still modest at 2.1%, which is in line with inflation. This suggests that even if the labour market seems healthy from a headline number perspective, a lack of dynamism in the labour market could suppress wage growth.
Does the dashboard already warrant a change in policy?
The broad measures of the labour market suggest that progress has been made, but slack remains. Over the next coming months, the slack should dissipate though. We expect that job openings will continue to gradually increase and that this will bring more dynamism to the labour market. However, structural features in the labour market will keep the participation rate low, the underemployed and long-term unemployed at elevated levels from a historic perspective.
Indeed, despite the lower unemployment rate we think the participation rate will not rebound in the short-term. That is, in the past few years, an ageing population has been retiring and leaving the work force. The problem is that the share of workers aged 65 and over is expected to increase by 2 percentage points in the coming five years, adding to further downward pressure in the rate. Moreover, we think there is little room for much more improvement from a cyclical perspective. In the past year, the curve has flattened as workers that were forced to leave the labour force, have come back. As a result, we think the cyclical shortfall in the participation rate has diminished and the structural features are now taking the upper hand. The view of the Chair of the Fed is that structural factors have played a role in the decline of the participation rate but that discouraged workers, resulting from a weak labour market are also a cause. These workers according to her need to be brought back to the labour force, which until now has justified loose monetary policy.
As for the long-term unemployment rate, we think it will remain high for some time. Workers that have left the labor force for an extended period are likely to lose their skills and social networks. Even if the economy improves, reintegration will be difficult. Therefore there is little that monetary stimulus can do and only structural measures, such as special training could help this group of unemployed.
Another indicator – the underemployed – the part-time unemployed that want to work full time, will likely improve as the economy recovers, but we think it will not revert to the pre-crisis rate. Structural factors such as the shift from a goods producing economy towards services economy will continue to favour part-time hiring. Meanwhile, the rapid pace at which this indicator increased during the recession could be concealing cyclical factors. In this case it is more difficult to pin down the structural from cyclical effects.
All in all, in weighing these competing forces and the changes that have taken place in the labour market, we think that the labour market is close to its potential. In other words we don’t think much slack is left. At the same time, we expect that the FOMC will leave monetary policy unchanged for the next few quarters to reduce labour underutilisation. As a result in the coming few quarters, we expect a gradual improvement of the weaker indicators of the dashboard, particularly the turnover indicators, leading the Fed to conclude that slack has faded. Moreover, in the second quarter consumer prices measured by the PCE price index, has been rising more quickly than expected by the Fed. PCE is currently bordering 1.6%, on the lower bound of the 1.6%-2% target from the Fed. Overall, we think the Fed will start to raise rates from June of next year onwards. This is a few months earlier than the FOMC is signalling. In addition, it implies that financial markets are pricing in too low a trajectory for the fed funds rate next year.