What Kind of Improvement Does the Fed Want?
Over the past few years observing changes in Federal Reserve interest rate policy has been a little like watching paint dry or grass grow...only not as exciting. That's because the Fed has not changed its benchmark Fed Funds rate since 2008 (Federal Reserve, FOMC). So with nothing else to talk about, Fed observers have focused on the minute changes in language that are included in Fed Policy statements. The minuscule revision in the July statement was the inclusion of the word "additional" to the "labor market improvements" that the Fed wants to see before finally pulling the trigger on its long-awaited rate increases. That should lead to a discussion of what kind of "additional" improvements those could be.
According to a good many of Main Street analysts, the labor market has already improved significantly over the past 5 years. During that time the unemployment rate has declined from 9.8% to just 5.3% (Federal Reserve Economic Data (FRED), St. Louis Fed). In the FOMC's June 2015 Summary of Economic Projections, Committee participants' estimates of the longer-run normal rate of unemployment had a central tendency of 5.0 to 5.2 percent. But that's not the kind of labor market success that has spurred Janet Yellen to action. She is looking for "additional improvements." Since it is very unusual for the unemployment rate to fall below 5% (having done so in only ten years in the 45 years since 1970), it must be that she is looking for improvements in other employment metrics, like wage growth, labor force participation, and the ratio of full time to part time job creation. On those fronts there is very little to inspire confidence.
In late July the Dept. of Labor released the Employment Cost Index, which is considered the broadest measure of labor costs, that showed an increase of just .2% in the second quarter. Incredibly, this was the index's smallest quarterly increase since it was created back in 1982. The result came in far below the consensus expectation for an increase of .6%. If you believe as I do that the inflation measures that the government uses to calculate GDP growth are understated (its last GDP report assumed zero percent inflation) then such a minuscule change in wages would suggest that workers are losing ground, not gaining.
But last week the Wall Street Journal's Jonathan Hilsenrath, who is by many considered the most well-connected reporter to the Fed's inner decision makers, posted an article citing recent Fed studies that show how wage movements have an uncertain effect on consumer prices. And given the Fed's consistent concern about "too low inflation", this leads him to the conclusion that wage growth may not be considered an important driver of monetary policy.
So perhaps Yellen would be spurred to act by improvements in the labor participation rate, a metric that she has always talked about in reverential terms. But on that front she won't find much to cheer about either. Today's jobs report, though widely reported as a positive one, saw no change in the unemployment or participation rates. In fact, seasonally adjusted, July set a new record for those not in the labor force at almost 94 million people. And the headline number of 215k jobs was one of the weaker reports of recent years, all of which have not, as of yet, prompted a rate hike.
As the unemployment rate has crept steadily downward, the participation rate has moved down with it. In fact, more people have dropped out of the labor force in recent years than have actually found jobs. In June, a staggering 640,000 Americans gave up on job hunting (Bureau of Labor Statistics, 7/2/15), pushing the participation rate down to 62.6%, the lowest figure since 1977 (FRED, St. Louis Fed). And contrary to the spin put on by the White House Council of Economic Advisers, these are not retiring baby boomers. Older people are actually staying in the workforce longer. Rather, these are prime age workers who have simply given up looking for work.
In 2014 the Labor Department estimated that in June of this year 6.4 million workers who wanted full time work were just working part time jobs. This "involuntarily underemployed" category includes 56% more workers than it did in 2006.
Such labor weakness would help to explain another recently released data set that shows that the economy remains much weaker than economists have expected. Last week we got the first look at Second Quarter GDP figures, which everyone hoped would confirm that the near-recession level figures of the first quarter were just a speed bump rather than a serious ditch. In fact, the numbers in the first quarter were so bad that they convinced government statisticians to go back to the drawing board to reformulate their GDP calculation methodology in order to eliminate the "residual seasonality" that many claimed was behind the disappointingly low Winter GDP results.
The good news is that the new formula did revive First Quarter (it's now positive .6% instead of negative), and also showed that the second quarter rebounded modestly to 2.3% annualized growth (Bureau of Economic Analysis (BEA)). The results were enough to generate happy headlines from the pushover media establishment that declared the economy was back on track. But most reports failed to mention that most observers had expected First Quarter to be revised much higher (the Fed itself had estimated that Q1 GDP could be as high as 1.8% annualized if better seasonal adjustments were used) and that the 2.3% for Second Quarter was well below the consensus forecast.
But the reduction in residual seasonality, which boosted First Quarter results, compelled the government to revise down other quarterly figures for the prior two years. The net result is that since 2012, the economy has not grown by an average of 2.3% per year as originally reported, but by just 2.0% (BEA). This makes what was already the weakest post-War expansion considerably weaker than economists believed. Maybe they will call for the revival of residual seasonality?
So barring any further revisions to First Half 2015 GDP, (which are much more likely to be revised down not up), our economy is running at an annualized pace of just 1.45%. To even get to the 2.3% annual growth rate, which represents the extreme low end of the Fed's "central tendency" for 2015, the economy would have to grow at 3.15% annualized in the Second Half. That is looking extremely unlikely. If we fail to hit those numbers, 2015 will be the ninth consecutive year in which the economy failed to reach or exceed the low end of its forecasts.
The weak labor market and the weakening economy may explain a couple of trends that should not be occurring in a strengthening economy: Americans' growing love for old cars, and the high rate in which young people of working age remain living with their parents.
Recent statistics show that the average age of America's fleet of 257.9 million working light vehicles had an average age of 11.5 years, the oldest on record. The IHS Automotive survey (7/29/15) also showed that new car buyers were holding on to their vehicles for an average of 6.5 years, up from 4.5 years in 2006. When workers are doing well they tend to buy new cars more often. When things are lean they hold onto their rides longer. Interestingly, this trend has occurred while Americans are taking on more leverage in car loans.
Similarly a recent study by Goldman Sachs, from Dept. of Commerce data, shows that the percentage of 18-34 year olds who live at home, which had shot up during the recession of 2008, finally began to decline slightly in 2014, but that declinestopped at the beginning of 2015. USA Today (8/5/15) noted that the number of Millennials living at home increased from 24% in 2010 to 26% in the first third of 2015, according to a Pew Research Center report, based on Census Data. Why would this be happening if the economy was really growing?
Since the unemployment rate seems unlikely to drop and both wage growth and increased labor participation show no signs of life, and the percentage of those who want to work full time, but can't, is still highly elevated, should we conclude that the Fed will move forward with its rate hike plans this year? If Janet Yellen is being honest that the Fed will not raise rates until we have further improvements in the labor market and those improvements seem to be nowhere in sight, then why doesn't she just admit that the Fed will not be raising rates any time soon?
If GDP growth only averages 2.0% in the Second Half (which I think is likely), then 2015 growth will only be about 1.7% annually. Given that the Fed didn't raise rates in 2012, 2013, and 2014, when growth was well north of 2%, why would they do so now? Yet Wall Street and the media stubbornly cling to the notion that 3% growth and rate hikes are just around the corner. Old notions die hard, and this one has taken on a life of its own.