Investors have received a harsh lesson about listening only to Federal Reserve official’s talking points and reading just the small forecast table attached to its policy statements to gauge what the Fed is going to do next. Was there a failure on the Fed’s part to communicate – or a failure of investors to pay attention?
While many believed the Fed went back on its word by not reducing bond purchases, as widely expected, at the conclusion of its Sept. 17-18 policy meeting, the truth is the weak signals from the economic data used to justify its decision were there for all to see.
Monetary policy is a complex process; the Fed sifts through a massive set of economic indicators to reach a decision. Nowhere is the complexity of an economic sector more understated than the unemployment rate, which the Fed uses as its summary measure of labour market expectations. It stood at 7.3 per cent in August, down from more than 8 per cent a year earlier.
Policy makers have long been aware of the shortcomings of the unemployment rate. Indeed, Fed Chairman Ben Bernanke noted recently, “The unemployment rate is not necessarily a great measure in all circumstances of the state of the labour market overall.”
An understatement from the Fed chief, to put it mildly. There’s a broader selection of labour market indicators that deserve more investor focus than they currently get.
Part of the decline in the unemployment rate is due to the decline in labour force participation, which is currently 63.2 per cent, down from 66 per cent before the onset of the Great Recession. If labour force participation had not shrunk, the unemployment rate would still be over 11 per cent. To be sure, a structural downward shift in labour force participation is occurring as the bulge of older workers move into retirement – but there are cyclical forces at play as well.
The real focus for investors should be on the age segments that have been depressed by cyclical forces – youth (16-24 years old) and core workers (age 25-54). Youth labour force participation dropped almost 5 percentage points since 2007, as tough labour market conditions keep young adults in schools. Even the core adult segment of the population has recorded a 2-percentage-point decline in labour force participation over the same period. Combined, these two segments outnumber older workers by a factor of 5-to-1. As the economy improves, their return to the labour market will slow the pace of unemployment-rate decline – and perhaps meaningfully so.
Another issue is mis-measurement of the unemployed. The broader measure of unemployment, termed U6 by the Bureau of Labor Statistics, which includes discouraged workers and persons working part-time but would prefer more hours, stood at 14 per cent in August. Fed expectations for this metric can be ball-parked. Using the long-run average spread between U6 and the conventional unemployment rate and then adding on the Fed’s long-run estimate of the unemployment rate, it suggests a Fed target of about 9 per cent to 9.8 per cent for this broader unemployment rate.
Moreover, even workers claiming full-time employment can be underemployed. For example, surveys of recent university graduates indicate that almost half of those who obtain jobs are in positions below their skill level. In older workers, under-employment can be traced to the disappearance of “middle-skill” jobs, such as bank employees, assembly line workers and truck drivers, according to a recent paper by Fed staffers. As noted in the study, these jobs have been disappearing from the labour market for decades. Other studies on the subject suggest that middle-skill jobs disappear at an even faster rate during a recession, which makes it even harder during a weak-recovery period to obtain an appropriately challenging job.
Finally, most market participants tend to focus on rates, or rates of change, when it comes to labour-market statistics. But as economist Paul Krugman has pointed out, levels matter as well.
It is fine to say the unemployment rate has dropped by 0.8 percentage point in the past year, and growth in payrolls has averaged 184,000 per month. But if the economy had hummed along at what its normal potential for the past five years, rather than sliding into a deep recession followed by a painfully slow recovery, the level of employment would be at least 14 million jobs higher than it has now. Unemployment might be coming down, but the labour market is far from whole again.
If you assume potential growth of 2.3 per cent (that’s the mid-point of the Fed’s long range GDP forecast), then employment growth at that level should be about 1.5 per cent a year – which works out to about 200,000 per month. That means that every month that the economy adds less than 200,000 jobs, that 14-million-job deficit is getting even bigger. Indeed, in order to close that gap over the next decade, the U.S. economy would have to create 340,000 payroll positions per month, on average; a daunting pace, not seen on a regular basis since the 1990s.
Expectations for next Friday’s U.S. payroll report for September have edged up to about 177,000, which may be sufficient to edge the headline unemployment rate down another notch. But savvy investors should be immediately turning to page 2 of the report, and beyond, before shifting any bets on the Fed’s next move.
Sheryl King is an independent macroeconomic strategist with more than 20 years experience in the international financial industry and central banking.