Fed Chairman Yellen Puts On a Brave Face

Federal Reserve Chair Janet Yellen, in her semi-annual monetary policy report to Congress on July 15, did her best to put some lipstick on the pig that is the US economy. She started with the relatively bright side - that the labor market had added 230,000 jobs per month over the first half of the year while the unemployment rate had dropped to 6.1 percent in June. It was all downhill from there.

First, Yellen noted that real GDP was, "estimated to have declined sharply in the first quarter." The first quarter's negative 2.9 percent growth rate is truly troubling. In the post-World War II period, growth rates that low have only been seen during recessions - and the one exception to this includes a negative quarter that preceded a recession. Yellen noted that the decline appears to have been due to transitory factors and hoped that growth rebounded in the second quarter but added, "this bears close watching." Among the things being closely watched is the housing sector which has continued to disappoint the Fed and others as its recovery has stalled. Even the labor market gloss is very thin. Labor force participation is weak, and when adjusting the unemployment rate for dropouts from the labor force, the actual rate is closer to 12.1 percent while wages continue to grow at a level about equal to the inflation rate, meaning that real wages continue to stagnate.

One would expect a little bit more reflection from the Fed Chair on the discrepancy between a modestly improving labor market and a sharply negative growth rate for the economy. Actually, neither metric is suggesting a strong economy. The growth of employment has been far below average since the official June 2009 start of the current weak recovery. See the red line in figure 1. From the start of this tepid recovery in June 2009 to June 2014, the economy had added 6.5 million fewer jobs than would have been the case 5 years into a normal post-WWII recovery. That is about half the usual job growth during 5 years of recovery.

Figure 1. Total Nonfarm Employees (Normalized at 100)

Source: US Department of Labor, Bureau of Labor Statistics

There really is no disconnect between very weak GDP data and "better" labor market data.  Weak GDP data simply reflects the cumulative impoact of a very weak labor market that has persisted since 2008.  Beyond the persistently sub-par employment growth shown in figure 1, the most obvious symptom of a weak labor market has been stagnant real wages that have undercut purchasing power for households.

Slow conumption growth has, along with substantial policy uncertainty enhanced by experiments with monetary policy, left producers reluctant to add capacity - that is, invest. As figure 2 shows, investment has been unusually weak as has consumptions growth, hampered by stagnant real wages.

Figure 2. Year-over-Year Change in Real Private Nonresidential Fixed Investment

Source: US Department of Commerce, Bureau of Economic Analysis

At the end of her discussion of the economy, Fed Chair Yellen adds, "As always, considerable uncertainty surrounds our projections for economic growth, unemployment, and inflation." That is certainly an understatement.

On the policy front, Yellen indicates that the Fed is in a cautious watch-and-wait mode. If the economy picks up, the current monetary accommodation will be phased out and the fed funds rate will begin to rise - perhaps to 1 percent from the current 0.25 percent by the end of 2015. However, acknowledging that, "the outlook for the economy and financial markets is never certain," Fed Chair Yellen allows that, "if economy performance is disappointing, then the future path of interest rates likely would be more accommodative than currently anticipated."

All that said, a brutally frank Fed Chair's testimony on the economy and monetary policy might go as follows: We have been trying to boost the economy for 5 years and have achieved relatively little in terms of persistent growth and/or improvement in the underlying labor market. What we have achieved is a rise in asset prices as the persistence of low interest rates has forced more market participants to reach for yield, thereby pushing up the prices of some dodgy, risky stocks. As Fed Chair Yellen acknowledges, some, "valuations appear stretched and issuance has been brisk. Accordingly we are closely monitoring developments in the leveraged loan market and are working to enhance the effectiveness of our supervisory guidance." Fed Chair Yellen here is flirting with the notion of identifying and popping a financial market bubble. But fear not, the Fed will not undertake such steps.

Eventually the realization will dawn that the only way to get the economy moving again is to work on the supply side. Specifically, that means undertaking measures to boost investment and produce a rising capital stock which will boost labor productivity, hiring, and GDP growth without inflation.

Three specific measures to boost capital spending are: (1) enactment of accelerated depreciation provisions and investment tax credits; (2) a sharp reduction in the corporate tax rate from 35 to 15 percent to, among other things, induce corporations to repatriate the $1.59 trillion of accumulated profits being held abroad to avoid the huge tax bill that would result if those corporations brought those earnings home; and finally, (3) a concerted White House-led effort to set a clear, less burdensome path for healthcare and other regulatory measures as a means to reduce investment dampening uncertainty.

While most of these proposals lie outside the purview of the Fed's traditional responsibilities, some acknowledgement that such measures are needed coming from the Fed might actually prompt the White House and Congress to end their stalemate and begin to undertake steps to help the economy grow. I'm not holding my breath but perhaps after the mid-term elections in November - the outcome of which might be influenced by sub-standard economic performance - the leadership in Washington, both in the Congress and White House, will see the need to move ahead with supply side reforms.