The Fed’s gamble on surplus labour

In recent weeks, the US Federal Reserve has buoyed markets by adopting a more gradual approach to policy normalization. Fed Chair Janet Yellen’s most recent public remarks, in late March, were more dovish than anticipated. And, at its last meeting, the Fed suggested that it would pursue two, rather than four, quarter-point interest-rate hikes in 2016. In response, investors have sold the US dollar and bid up equity prices and US Treasuries, and commodities and emerging-market assets have surged. At first glance, these developments are curious. For one thing, the Fed’s decision appears to be at odds with signs that US inflation is accelerating. If, as some have suggested, the Fed is responding to fears about global growth, it would not make sense that risk assets – above all commodities and emerging markets – are rallying. But there is a logical thread that explains these apparent inconsistencies, one that centres on a potentially high-stakes Fed gamble. Before we get to that wager, it is worth considering other proposed explanations for the market rally. The first centres on monetary easing by the European Central Bank and the Bank of Japan. But negative interest rates and flat yield curves harm banks’ earnings; links between extraordinary monetary policies and growth or inflation remain tenuous; and surely monetary policy is subject to diminishing returns by now. Another view focuses on OPEC countries’ oil-supply restraint, claiming that it is helping to support oil prices and thus high-cost producers in North America. But this logic rests more on correlation than causation. OPEC has not decided to cut production, and only a handful of its members have agreed to freeze output. A genuine reduction in global excess supply awaits a decline in output, as existing wells, deprived of capital investment, run dry. A more plausible explanation for improved market performance is waning pessimism. Fears of recession in the United States, the United Kingdom, or Germany – countries with full employment and rising real household incomes – were always a bit odd. So was the notion that financial-market gyrations would have the atypical impact of significantly denting household or corporate spending. And in China – a country that may be experiencing slowing GDP growth, but is nowhere near recession – rising household income and consumption are helping to offset the decline in fixed-asset investment. This brings us back to the Fed and its gamble. Policymakers’ change of heart likely arose from a re-think about slack in the US economy, especially in the labour market. Indeed, in her recent remarks, Yellen noted that the labour-force participation rate had “turned up” and that “room for improvement” remained. If the Fed now believes that the economy has greater capacity for above-trend expansion without generating much inflation, it can, to paraphrase John Lennon, “give growth a chance.” Faster growth and slower policy tightening are great news for asset prices. A gentler Fed also means less risk of dollar appreciation – an unambiguous benefit for commodity markets and dollar-indebted emerging economies. Finally, a stable dollar takes pressure off the renminbi, which should slow outflows of “hot” capital from China, removing another source of risk from the global financial system. Given these implication, it is little wonder that markets turned up. But with US core inflation on the rise, the Fed is taking a big risk. After all, the core consumer-price index is already at 2.3%, led by 3.1% inflation in services (both figures are up by more than half of a percentage point year on year). Housing inflation, which comprises about a quarter of the CPI index, has also accelerated, to 3.2%. And price growth in health-care services, which had slowed in recent years, has jumped to 3.9%, double the rate recorded a year ago. The Fed prefers to watch core “private consumption expenditure” inflation, which stands at a more subdued 1.7%. PCE goods prices are still falling, and services prices are rising just 2.1%, roughly unchanged over the past year. But the focal point for the Fed is the labour market. According to a March report, the civilian participation rate has increased by half a percentage point from its September 2015 lows, and now stands at 63%. The same survey indicates that nearly six million Americans, who are not currently in the labour force, want to work. Another six million are working part-time for economic reasons. In part, low levels of US labour-force participation reflect structural factors. Nearly every sub-category – by gender, education level, age cohort, or race – has been declining in the US since 2000. Yet labour supply is typically also cyclical, picking up as the economy improves and job opportunities arise. Until now, that cyclical pattern has been absent in the post-crisis “new normal.” What might an increasingly elastic labour supply mean for Fed policy? The answer depends on how much surplus labour is available. Suppose it is 1.5 million workers – a conservative figure that would still leave the civilian employment-to-population ratio well below its post-war peak. At plausible rates of US job creation, it would take 12-18 months to absorb those new entrants. That labour influx would dampen wage and price pressures, allowing the Fed to proceed gradually with interest-rate normalization. The bigger the pool of available labour, the longer the Fed can go slow. This recalls former Fed Chair Alan Greenspan’s experiment in the late 1990s, when he let the US economy boom, on the hunch – which proved to be right – that productivity was accelerating. Might Yellen be willing to make a similar wager on labour supply? For now, the politics of populist discontent – from Donald Trump’s presidential campaign to the potential of a British exit from the European Union – are capturing the world’s attention. But the US employment and inflation reports are the real sources of clues about the future. It is there that one should look for the factors most likely to drive the biggest wagers – for policy and for markets alike.