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The minutes of the Federal Open Market Committee meeting on March 13 have surprised the markets. The committee seems to have shifted in a markedly more hawkish direction than was reflected in the statement issued after the meeting, and the bar to quantitative easing 3 now seems to be rather high. Perhaps we should have expected this, given the fact that speeches by chairman Ben Bernanke and Bill Dudley since the meeting had given no hint of any further easing. But the breadth of the committee’s shift away from easing was certainly not expected.
It is easy to find hawkish phrases in the minutes. The US Federal Reserve staff has not only upgraded its real gross domestic product projections, and increased its inflation forecasts, but has also reduced its estimate of the output gap. Only “a couple” of FOMC members saw any case for further easing, and then only if growth falters or inflation falls below target. There was even some discussion of changing the guidance on keeping short rates “exceptionally low” up to the end of 2014, a move which would really shock markets.
Nevertheless, it would be very premature to conclude that the Fed is close to tightening policy. Much of the debate revolves around the recent behaviour of the labour market, where Mr Bernanke still seems to be on the dovish end of the spectrum.
In January, the Fed chairman stoked expectations that QE3 may be just around the corner when he said the following:
“If recovery continues to be modest and progress on unemployment very slow, and if inflation appears to be likely to be below target for a number of years out "“ so the configuration we're talking about in the projections "“ then I think there would be a very strong case, based on our framework, for finding a different "“ additional tools for expansionary policies or to support the economy.”
In an important speech last month, Mr Bernanke again concluded firmly that cyclical unemployment is far too high. But, significantly, he did not suggest that there was still a “very strong case” for “additional tools” to support the economy. He is probably biding his time, waiting for clearer evidence from the labour market that more action is needed.
There are three areas of uncertainty in the labour market which the Fed will be watching carefully.
1. Okun’s law
As noted here, the most recent decline in unemployment has been faster than would have been expected, given the reported rate of growth in real GDP. The chairman focused on this in his recent speech, saying that the abnormally large decline in unemployment in 2011-12 was simply a reversal of the enormous shake-out of labour, relative to GDP, seen in the depths of the 2009 recession. He is right about this.
The first graph shows the results of some recent work by Zach Pandl of Goldman Sachs, which estimates the difference between the level which unemployment should have reached, given the behaviour of GDP, and the level it actually did reach. The labour shake-out in 2009 is very clear, as is the “shake-in” in recent quarters. If the GS work is right, then unemployment is now back to normal, and should not drop any further unless GDP accelerates to an above-trend rate. The implication of this, if it is confirmed by upcoming data, is dovish for policy.
2. The Beveridge curve
The relationship between unemployment and vacancies is called the Beveridge curve. Since both of these variables measure labour market slack, they should be inversely related to each other in a fairly predictable manner: higher unemployment should imply fewer vacancies, and vice-versa. However, in the current recession, unfilled vacancies have been stubbornly higher than they “should” be, given the level of the unemployment rate. (The Beveridge curve, shown below, has therefore moved out to the right.) This suggests that companies may be struggling to find suitable workers to fill the available jobs in the economy, in which case the labour market is tighter than would be implied by the unemployment figures.
Mr Bernanke considered this possibility, but suggested that vacancies may be taking some time to adjust to the severity of the recession, while unemployment has risen more rapidly owing to the dramatic rise in lay-offs during the recession. If so, vacancies should soon start to fall, and the Beveridge curve will move back to its normal place. If this happens, the implication would be dovish.
However, it must be said that this is taking an awfully long time to happen, if it is going to happen at all. Peter Newland of Barclays Capital, from whom the above graphs are taken, suggests that we may be seeing a repeat of the 1970s economic cycle, in which the outward shift in the Beveridge curve was never reversed during the subsequent economic recovery. The structural level of unemployment had therefore risen permanently, with hawkish implications for monetary policy. This will be watched carefully by the Fed.
3. The labour force participation rate
Since 2008, there has been a rapid decline in labour force participation, which now seems to have been mainly due to the ageing of the labour force, rather than to the rise in disaffected workers who cannot find a job during the current recession. This implies that many people may have left the labour force permanently, and therefore that they will not be available to boost the labour supply if the economy recovers further. The last graph shows the results of a recent study by the Chicago Fed, which concludes that demography has already reduced the trend participation rate significantly and will do so much more in the next few years. The implication of this, if it happens, is hawkish, since it reinforces the Fed’s worries that the output gap may have declined.
So where does all this leave us? With wage inflation still very low, the FOMC members seem most unlikely to jump to the conclusion that excess unemployment has now been eliminated. Nor should they. But, in their minds at least, the case for QE3 in the near term seems to have evaporated.
Gavyn Davies is a macroeconomist who is now chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners. He was the head of the global economics department at Goldman Sachs from 1987-2001, and was chairman of the BBC from 2001-2004. He has also served as an economic policy adviser in No 10 Downing Street, an external adviser to the British Treasury, and as a visiting professor at the London School of Economics. Gavyn Davies is an active investor and may have financial interests and holdings in any of the topics about which he writes. The views expressed are solely those of Mr Davies and in no way reflect the views of Prisma Capital Partners LP, Fulcrum Asset Management LLP, their respective affiliates or representatives. This material is not intended to provide, and should not be relied upon for, investment advice or recommendations. Readers are urged to seek professional advice before making any investments. To comment, please register for free with FT.com and read our policy on submitting comments. All posts are published in UK time. See the full list of FT blogs. FT.com latest global economy newsChina to let in more foreign investmentSpanish minister presents "?extreme' budgetEurozone weighs union on bank regulationFed steps back from further easingShares slip after Fed dashes QE hopesMost popular posts Spain in the austerity trap Why the Fed has taken QE3 off the agenda The optimal speed of fiscal adjustment A better era for global equities ECB liquidity is not a free lunch “You can’t solve a debt crisis with more debt” A “healthy” rise in global bond yields Assessing the risk of a fiscal crisis The metamorphosis of Ben Bernanke Thinking the unthinkable on a euro break-up Blogroll Abnormal Returns Baseline Scenario Brad DeLong: Grasping Reality with Both Hands Fed Paper Greg Mankiw’s blog Martin Wolf’s Exchange Naked Capitalism Paul Krugman: Conscience of a Liberal Peterson Institute for International Economics Roubini Global Economics Vox Categories Asia Banks Central Banks China Currencies Emerging markets Eurozone Germany Global economy IMF japan Macroeconomics Middle East Monetary policy Oil Recession Regulation Sovereign debt Sport UK US In the news.utcw-tag-link{background-color: !important;border-style:none !important;border-width:0px !important;}.utcw-tag-link:hover{background-color: !important;border-style:none !important;border-width:0px !important;}Angela Merkel Bank for International Settlements Bank of England Ben Bernanke bond yields budget deficit Bundesbank central banks credit crunch ECB EFSF europe European Central Bank Fed Federal Reserve FOMC George Osborne Germany Greece housing IMF Inflation jobs Larry Summers liquidity trap Mario Draghi Mario Monti Martin Wolf Nicolas Sarkozy oil Paul Krugman QE QE2 QE3 Richard Koo Rudesbusch single currency Stability and Growth Pact Swiss National Bank Taylor Rule The Fed Twist unemployment us US economy clientAds.fetch(AD_MPU); clientAds.render(AD_MPU); Archive « MarApril 2012 M T W T F S S 1 2345678 9101112131415 16171819202122 23242526272829 30 function show_micro_ajax(response){document.getElementById('wp-calendar').innerHTML=response;} function microAjax(url,cF){this.bF=function(caller,object){return function(){return caller.apply(object,new Array(object));}}; this.sC=function(object){if(this.r.readyState==4){this.cF(this.r.responseText);}}; this.gR=function(){if(window.ActiveXObject) return new ActiveXObject('Microsoft.XMLHTTP');else if(window.XMLHttpRequest) return new XMLHttpRequest();else return false;}; if(arguments[2])this.pb=arguments[2];else this.pb="";this.cF=cF;this.url=url;this.r=this.gR();if(this.r){this.r.onreadystatechange=this.bF(this.sC,this);if(this.pb!=""){this.r.open("POST",url,true);this.r.setRequestHeader('Content-type','application/x-www-form-urlencoded');this.r.setRequestHeader('Connection','close');}else{this.r.open("GET",url,true);} this.r.send(this.pb);}} Elsewhere on ft.com Money Supply
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