Fed Officials Expect Overshooting Unemployment Rate

Following the Fed's March 18-19 meeting, the policy making committee provided a collection of charts showing the projections of macro economic main variables in the coming years. Before discussing the projections, I should note here a little bit of confusion I have. In the projection file, it states that these projections are "based on FOMC participants’ individual assessments of appropriate monetary policy." Therefore, these number's aren't actually projections as done by someone outside of the Fed, but these are the expected values of these economic variables that could be seen according to Fed officials' own appropriate policy. 

In other words, when looking at these projections, we should take into consideration that these projections are influenced by each committee member's policy recommendation.

The recent post on the WSJ touches on how this projection could be misleading the market into expecting that interest rate rise will come sooner than expected. According to the article, some Fed's policy committee members raised their expectation of interest rates in 2015 and 2016. This could signal market that the Fed policy makers are looking at possible rate increase which is sooner than expected prior to March meeting.

 From the above chart we could see what rate Fed officials are expecting fed funds rate target to be in 2014, 2015, 2016 and long-run. In 2014, according to the chart, we see that the policymakers almost unanimously expect the fed funds rate target be at the current level of 0 to 0.25 percent target. In 2015 and 2016, the averages of the Fed officials' expected fed funds rate are around 1 percent and 2.5 percent, respectively. The policy makers expect the rate to be around 4 percent in the long-run. This rate is slightly lower than the historical average of the fed funds rate target since 1990, which is 4.2 percent. In general, the committee members expect to have similar fed funds rate target that it has had since 1990.

Note that, the expected fed funds rate target is still lower than long-run expected rate of 4 percent at around 2.5 percent in 2016. Hence, it is plausible that somewhat easy monetary policy will be taking place until 2016. But we should always remember that low interest rate doesn't always mean expansionary monetary policy as Milton Friedman put it, "After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die."

The surprise of the projection comes when we look at another chart which was included in the same projection report. The following chart shows how the committee members expect the unemployment rate to be under appropriate policy in coming years and in the long-run.

 The central tendency among the policy makers regarding the expected unemployment rate in 2016 is along with the long-run projection: at 5.2-5.6 percent.

So, what can we conclude about the Fed's future policy from these two charts?

The Fed policy makers are believing (or seems to be) that under appropriate policy, the Fed will be pursuing expansionary policy even after the unemployment rate reaches the long-waited long-run average. In other words, the Fed policy makers think overshooting the unemployment rate is a viable option for the Fed policy in coming years. This is along the line with the worry about low inflation in coming years. Another chart in the projection shows how the policy makers expect inflation to be in coming years.

 As we see from the chart that central tendency among the officials regarding the expected inflation in 2016 is below the Fed's target of 2 percent inflation. It is kinda counter-intuitive; they target 2 percent, but expect it to be below it. Or are they really targeting 2 percent?

Then, given the the below target inflation rate, the Fed officials shouldn't be worried about their fed funds rate target expectation below the long-run expectation.

From the Fed officials' projection, we can conclude that the Fed will be still operating somewhat stimulus policy in 2016 relative to their long-run policy.- if we assume these projections are made with rational expectation

Shedding Light on the Labor Force Participation Rate

Original post on March 10th, 2014
Last Friday, February job report came with a little surprise of higher than expected job growth of 175,000 and an increase in the unemployment rate to 6.7%. The increase in the unemployment rate came from non-participants getting into labor force in last month. While we watch the FED's move to wind down QE and plan on raising the interest rate as the economy slowly recovers, we should look at more data to see whether the recovery is bringing back the U.S. economy to the track. A recovery should bring back the economy to the long run trend.

The puzzle we see after the recession is a historically low level of the labor force participation rate. The labor force participation rate is unchanged February at 63.0%, which is the lowest in 35 years. The following graph shows the labor force participation rate (LFPR) for the total population and population from age of 25 to 54.

It is now clear that the LFPR for the total population has been decreasing since the onset of the recession. This decrease has partially been linked to the baby boomers' retirement since 2010. But increasing data we see is that the LFPR for the group of age of 25 to 54, the prime age workers, has also been decreasing during the recovery. For this group, retirement is less relevant to the decreasing LFPR. Therefore, we should worry that there might be a cyclical decline in the LFPR.

Timothy Dunne and Ellie Terry have recently written on the subject of low LFPR. According to them, a decrease in the LFPR for prime age workers is a key contributing factor to the low overall LFPR. They separated the effect of a change in the LFPR of each age group on the overall LFPR change. The following chart shows how change in the LFPR decomposes:in their own words on the result:

Three key results emerge. First, increases in labor force participation for the youngest age group boosted overall labor force participation by 0.075 percentage points. Second, the growing population share of the 55+ age group reduced LFPRs over the period by 0.21 percentage points, accounting for roughly 40 percent of the overall decline. Third, labor force participation for prime-age workers continued to fall. The combined within effect for the prime-age individuals (25–34, 35–44, and 45–54) reduced the participation rate by 0.28 percentage points—or a little over half of the overall decline in labor force participation. Additional declines in labor force participation were associated with the reduction in population shares of prime age workers.

In other words, we see that much of the decline in the LFPR has come from decrease in the LFPR for workers of age of 25 to 54. For this group, the LFPR was 82.5% when the recession ended; whereas it is now 81.1%. A question we should ask is whether the labor force participation rate can get back to its highest level of above 84% once the unemployment rate reaches its natural rate and the economy recovers (we should define when a recovery ends).

From the first graph, it seems like the LFPR reached its highest level at around 66%. Considering increase in retirement of baby boomers in coming years, getting back to this level of LFPR is unlikely even after a solid recovery. However, the recovery should bring the LFPR for the prime age workers back to its pre-recession level unless there are some structural factors that are reducing the rate. There is high possibility that the LFPR for prime age workers might not reach its high level as the economy recovers and the unemployment rate decreases. In this case, Christopher J. Erceg and Andrew T. Levin have suggested the  monetary stimulus policy to continue until some other labor market conditions, specially the labor force participation rate, pick up, not just until the unemployment rate drops to low level if the LFPR is still relatively low.

Is There Wage Inflation? and Is That a Problem for the FED?

In the recent Wall Street Journal's daily report, Jon Hilsenrath writes about a possible wage inflation happening in the U.S. job market as discussed by Torsten Slok and Joseph Lavorgna, who are both analysts at Deutsche Bank. On one hand, Torsten Slok points out that there has been increase in hourly earnings recently. Indeed, hourly earnings of production and non-supervisory workers increased by 2.5% from a year ago.

This surge in hourly wage could make the FED worry about inflation pressure and change their timeline of raising the interest rate. However, as Mr. Lavorgna points out, this increase in hourly earning could be just a result of a decrease in average weekly hours worked as the case where,indeed, the average weekly hours  worked has dropped for last three months.

This drop in average hours worked could be a result of a bad winter we are seeing right now. But we have to be careful when reading Mr. Lavorgna's argument. We should take his argument strongly only if most workers are salaried workers since earnings for salaried workers are fairly less uncorrelated to the hours worked than earnings for hourly waged workers. That hasn't been the case recently; 59% of the total workers were paid on hourly basis in 2012. Therefore, there are factors we should be careful about on the both sides of the argument on the possible wage inflation. Once sunny days come again, we should look at the same data on hourly wage increase and change in hours worked to see whether wage is accelerating. 

Now, let's turn to the question: if wage inflation is indeed happening, does that mean there is a possible inflationary pressure coming?

The idea behind inflation driven by wage inflation is that when there is increase in aggregate demand for some reason and a following increase in demand for labor from firms, increase in wage accelerates. Facing the accelerating wage, the firms would raise their product prices.

However, this argument for wage inflation driven price inflation lacks some other factors that could make make the price inflation unnecessary. As discussed by Gregory D. Hess and Mark E. Schweitzer in their paper "Does Wage Inflation Cause Price Inflation?", the wage increase could be from increase in labor productivity. Also, the argument that the firms will raise their price to pay higher wage for workers isn't necessarily true if the firms are in competitive market and have no power over the prices. Moreover, in their paper they concluded the other way around that price inflation could drive wage inflation. Even though more study is need on the subject, the FED could be not worried about the existence of the wage inflation and the consequence of it if it exists for now.

Edmund Phelps on the 80's High Unemployment Problem in Europe

In 2006, Edmund S. Phelps from Columbia was awarded the Nobel Prize "for his analysis of intertemporal tradeoffs in macroeconomic policy".  Phelps works have brought micro economics analysis in incentives of employers and employees to explain macro economic phenomena, unemployment and a natural rate of unemployment.

While studying his works, I was amused by his study on the 1980's Europe. During the first half of the decade, European countries experienced increasing unemployment rate.

His interest in the 80's Europe rests on a fact that there was no evidence of unexpected disinflation or deflation while unemployment rate was rising in the Europe. Rise in unemployment rate in Europe started when the most of the world experienced recession in the early 1980's. However, the unemployment rate in the Europe prevailed at the higher rate while unemployment in the US continuously decreased following a hike during the recession.

Then Phelps tried to solve this puzzle of high unemployment rate together with not so much deflation in Europe. First, he gave an argument on why this surge in the unemployment rate couldn't be explained by some fiscal tightening in Europe if it had one. He disproves fiscal austerity explanation for the unemployment rise by two parts. First, he just looks at the budget deficits of the leading countries in the area. He found that, in fact, there wasn't an evidence of fiscal tightening on the budget balance sheet. The following table shows that the following countries were having an easier fiscal policy than they had in 1980, when the unemployment wasn't high, during the first half of the 80s.  Moreover, he temporarily borrows a Keynesian hat and tries to see what Keynesian theory would say if there was indeed a fiscal tightening, and the the unemployed surge was caused by it. If there was a fiscal tightening during this period, decrease in the government spending or increase in tax would lower nominal interest rate according to IS-LM model "assuming that the supply of money is not permitted to change course in response." However, the empirical evidence doesn't support this Keynesian argument for high unemployment rate because the nominal interest rates in leading European countries except Denmark were higher during the period than they were in 1977.

Phelps further states:

"The evidence is all the more crucial when we reflect that, whatever the
cause, the resulting contraction of employment per se would tend to
slow the growth of nominal wages, thus to reduce the inflation premium
in nominal interest rates that borrowers are willing to pay, and hence,
other things equal, to lower interest rates. The rise of the average
European nominal interest rate is thus doubly hard to square with the
Keynesian fiscal hypothesis."

He finally gives some hope for Keynesian theory by offering a counterfactual argument that if there hadn't been fiscal tightening, the nominal interest rate, output and velocity of money would have been even higher. Therefore, according to Keynesian explanation, there was indeed fiscal tightening, that in fact lowered the nominal interest rate even though the nominal interest rate increased in absolute value. Therefore, Keynesian theory has no problem of telling the story of high unemployment in Europe. However, Phelps argues that in order for this Keynesian explanation to work, there has to be another contractionary shock other than fiscal tightening that raises the nominal interest rate while it contracts employment. If, according to him, there is not such another shock, a lone fiscal tightening would only lower the nominal interest rate in absolute term, but the nominal interest rate increased. To me, the interesting part of his argument is whether there could be a such contractionary shock that raises the nominal interest rate while contracts employment.

To explain this high unemployment period, Phelps proposed broader explanation for it which says that there was a change in the natural rate of unemployment. I will write about his explanation for rise in the natural rate of unemployment in a later post. To prepare my readers for that, I will end this post by quoting the conclusion of his paper (Phelps 1986, 509):

Our vision of the persistence of unemployment in Europe posits a
considerable degree of real wage stickiness, whether loosely imple-
mented through private understandings or enforced by public provisions
for indexation. If, to take the extreme case, the real wage of an employee
is a constant and if, as a consequence, the real cost savings (also
expressed in consumer goods) to the firm of laying off an employee,
which is the true cost of using the employee in production in view of any
benefits paid to the laid off, is likewise a constant, in the sense of having
been earlier predetermined for the course of his employment, a decline
in the real marginal-revenue productivity of labor as a result of devel-
opments such as a rise of markups, a real depreciation of the currency,
a fall of the real price of capital goods output, or a contraction of the
capital stock will cause some employees to be laid off. Further, unless
the real marginal productivity schedule is restored, laid-off workers will
remain laid off for the balance of their years as employees. In this extreme
case of real wage stickiness, it is only the entrance of new workers,
insofar as they can make deals for employment at reduced real wages in
view of the reduced marginal-revenue productivity of labor, that will
erode the average value of the real wage; but this statistical adjustment
will do nothing to put laid-off workers back to work. To the extent that
customer markets inhibit the rise of new firms to absorb the young while
contracts protect existing laid-off employees from being passed over for
recall in favor of hires of cheaper workers from the outside, new entrants
will end up bearing a share of the economy's unemployment-indeed an
increasing share as new entrants accumulate and the laid-off take the
places of retiring workers.

In the expectational sense, the equilibrium unemployment rate is thus
increased, and the natural rate with it. Yet their "long-run" values need
not have increased. (Also, it is not implied that the equilibrium rate
increased as much as the actual rate.)