A demotion for the labor market

| September 11, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Just a few years ago, the labor market topped the list of the aspects of the economy that governed Fed monetary policy. Chair Janet Yellen probably brought the labor market to the peak of its power and influence. But the changes announced by the FOMC after its strategic review included a de-emphasis of the labor market in determining when to raise rates. The FOMC has concluded that it has no idea what full employment is and no way to know when to pre-emptively take back accommodation, except by keying solely on inflation. In the current environment and arguably for the next few years, the labor market suddenly has become largely irrelevant.

Post-financial crisis liftoff

Many of the tools the Fed intends to deploy over the next few years were initially introduced after the financial crisis, when the FOMC first faced the constraint of the effective lower bound on its funds rate target.  The Fed used explicit forward guidance to help markets and the public understand the committee’s thinking.  At first, the FOMC went with date-based forward guidance, which proved problematic because it was viewed as not sufficiently sensitive to the evolution of the economy.

Then in December 2012, the FOMC switched to outcome-based forward guidance, indicating that it would likely remain at the ELB at least until the unemployment rate fell to 6.5%, as long as inflation projections did not move far above 2%.  Moreover, the length of the QE campaign, generally labeled QE3, which was the first not to have an explicit timeframe, was pegged to achieving “substantial improvement” in the labor market outlook.  Thus, both key parameters of policy were explicitly tied to the progress of the labor market.

Chairman Bernanke secured the initial taper of QE3 just before he left office at the beginning of 2014, but the FOMC under both Bernanke and his successor Janet Yellen set policy based almost exclusively on the perceived outlook for the labor market.  Yellen, in particular, had been focused on labor market issues as an academic economist and brought that emphasis to her stint as the top policymaker at the Fed.

The Fed’s nearly exclusive focus on the labor market was made possible to a large degree because inflation was quiet throughout that period.  Core inflation was consistently below the Fed’s 2% target, but it spent most of those years just a few tenths below 2%, so that policymakers felt no need to respond directly to price developments.  Instead, they aimed to hold the funds rate at the ELB until the labor market made enough progress to convince them that an economic relapse was unlikely.

As it turns out, the labor market improved more quickly than generally expected, at least as measured by the unemployment rate.  However, there was persistent weakness in labor force participation, so when the unemployment rate hit 6.5% in early 2014, the Fed was not ready to declare victory and begin raising the funds rate.  In fact, Chair Yellen spent most of the next two years highlighting various previously ignored labor market metrics such as the U6 unemployment rate and job leavers to explain why the FOMC believed that the labor market was not as healthy as the unemployment rate suggested.

Over 2014 and 2015, the labor market was king in terms of the FOMC’s policy deliberations.  Chair Yellen and other doves on the committee held off as long as they plausibly could, concocting various stories to cast aspersions on the performance of the labor market, but by December 2015, the Fed finally raised rates off of the ELB.  By that time, the unemployment rate had declined all the way to 5.0%, roughly consistent with where policymakers pegged long-run full employment.  Ironically, core inflation at the time of liftoff was at the lowest levels seen since the financial crisis, running in the low 1%’s.

Phillips curve rules

With inflation meandering aimlessly between 1% and 2% and no obvious short-term correlation with developments in the economy or the labor market, Fed officials, led by Chair Yellen, fell back to a Phillips Curve framework to project prices.  Yellen repeatedly focused on the labor market and in particular on wage pressures as the main driver of inflation, a reflection of the Fed’s traditional reliance on Phillips Curve models.  Even if inflation had begun to tick up in those years, Yellen would have written it off as a fluke as long as wage gains were muted, which they consistently were in those years. In essence, the dual mandate for full employment and price stability translated, on an operational level, to an exclusive focus on the labor market.

Powell > Phillips (Curve)

When Jay Powell took over after Janet Yellen, it marked the first time in decades that the central bank was not run by a trained economist.  Not surprisingly, Powell was not nearly as reliant on traditional economic models as his predecessors Bernanke and Yellen.  He has taken a much more empirical and agnostic approach to assessing the economy.

In particular, he staked out his new path for the Fed at his first Jackson Hole speech as Chairman in 2018, when he basically contradicted a Fed paper presented for the conference that argued the Fed should set policy based on labor markets, even when the link between the economy and wages on one side and inflation on the other is weak or uncertain.  Powell argued that economists could not know with precision where key unobserved variables, like full employment and r*, lay and that the traditional models were of limited value.

As it turns out, despite historically modest real GDP growth, the labor market went on a tear in the last expansion, with the unemployment rate sliding all the way to a 50-year low of 3.5%.  However, wages only accelerated modestly, and core inflation barely rose at all, spending most of the time below the Fed’s 2% target.

Chair Powell concluded, and most other Fed officials concurred, that the Phillips Curve was dead, which is to say that the labor market could run hot without sparking price inflation, as it had in previous decades and as it does in the Fed staff’s models.

New framework

The recently released update to the Fed’s strategic statement reflects these changes in thought.  The committee noted that it will seek to counteract “shortfalls” rather than deviations relative to estimates of full employment.  In other words, monetary policy will ease in response to weakness in the labor market, but it will no longer hike rates if the labor market is viewed as unsustainably hot.  Instead, the Fed is ditching any aspiration to know where full employment lies and will instead push the envelope unless and until the actual inflation rate moves sufficiently above the 2% target to create concern.

The discarding of the traditional relationships between the economy and inflation is premature.  Although the Phillips Curve specifically has been a poor tool, it seems foolhardy to conclude that inflation bears absolutely no relationship to the real economy.  It may be that these structural relationships have changed, but it may also be that the relationships have not changed much but were obscured by short-term or medium-term forces, such as globalization, that could fade over time.

In any case, the labor market has been demoted.  It will still be used when the economy is weak and the Fed needs to ease, but it has been relieved of its duties on the other side of the business cycle, when the Fed would normally be raising rates.

Empty vessel

The FOMC expects that it will be at least several years before it needs to contemplate rate hikes, but when that time comes, the new policy framework offers very little structure for the Fed to come up with a coherent policy approach.  There are several aspects to the lack of structure.

First, Chair Powell and the Fed have concluded, based on a single business cycle experience, that inflation no longer responds to the economy or to labor markets as previously assumed, but they have no alternative theory about how inflation is determined.  In effect, inflation is simply a mystery to the Fed, and since it has no ability to accurately predict inflation, it must simply react to it.  That might work out okay, but if inflation occurs with “long and variable lags,” as Milton Friedman famously said, then a reactive policy will always be behind the curve, an exercise in futility.  By the time the Fed realized that policy was too easy, the inflation genie will be out of the bottle.  By the way, this is exactly the approach that got the Fed in so much trouble in the late 1960s and 1970s.

Second, with no structural model to put moves in inflation into a macroeconomic context, the temptation will be to miss the forest for the trees.  If inflation does begin to accelerate, policymakers will be inclined to explain away any move by highlighting anomalies in the data.  This approach has arguably been appropriate in recent years, as most of the deviations in core inflation from trend—more often to the downside than to the upside—have been explained by one-off events unrelated to economic fundamentals, such as a shift in cell phone service terms in 2017 and changes to Medicare administered rates in the early 2010s.  However, if there is a significant shift in inflation fundamentals, the Fed is likely to miss it doubly, as it will be late because of Friedman’s lags and it will be even later because it will write off the acceleration for a time by focusing on the micro drivers.  Again, this is exactly how the Fed allowed inflation to get so far out of hand in the 1970s.

Third, for better or worse, the Fed now has little way of hoping to ascertain what policy constitutes easy versus tight policy.  If we don’t know what the equilibrium rate is or the full employment level of unemployment, then it will be impossible to know when Fed policy is too easy or too tight and by how much.  The Fed will simply have to set policy meeting by meeting, much like someone walking in the dark with a weak flashlight, never able to see more than a step or two forward.  This is the dream set-up for Chair Greenspan, who favored setting policy in an ad-hoc fashion, but it remains to be seen if the current cast of characters can replicate his legendary feel for the economy.  With no broader map to guide the way, it will be much easier for the Fed to stray far from its preferred path once it takes a modest misstep.

Finally, the lack of economic structure on the Fed’s strategy will strengthen the gravitational pull of other goals on the Fed’s decision-making.  Clearly, the FOMC is moving toward including some sense of social justice in its policymaking, as Chair Powell and others continually reference unemployment rates of various minority groups and one of the takeaways from the Fed Listens tour was the notion that low unemployment is good because it benefits traditionally low-income communities.  That new emphasis could even be codified in legislation next year, depending on the outcome of the elections in November.  This focus is well-received at the moment, but if the Fed is ignoring its traditional mandate to push for other gains such as a reduction in economic inequality that is has little or no power to achieve, it is likely to eventually run into trouble.

john.killian@santander.us 1 (646) 776-7714

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