Since Ronald Reagan broke the back of U.S. unions in the 1980s, Wall Street has had little time for labor economics. A glance at the unemployment rate or average earnings would tell an analyst all he or she needed to know about the economy and outlook for monetary policy, or so it seemed. No longer. Economists are poring over the U.S. jobs market, looking for clues to when the Federal Reserve Board might finally begin tightening after almost six years of its unprecedented zero-interest-rate policy. A surprisingly soft August employment report, released on September 5, underscored the challenge of the task.
Janet Yellen underscored the centrality of labor economics by making the topic the centerpiece of the annual symposium hosted by the Kansas City Fed late last month in Jackson Hole, Wyoming. The Fed chair offered a comprehensive survey of the labor landscape but gave nothing away about the timing of a policy shift. The jobless rate, then at 6.2 percent, “somewhat overstates the improvement in overall labor market conditions,” she explained, citing factors such as a falling participation rate and an increase in involuntary part-time work (see “U.S. Labor Indicators Offer Mixed Signals on Economy”).
Yet Yellen acknowledged that inflationary pressures might be masked by “pent-up wage deflation,” as companies that couldn’t reduce salaries during the recession try to keep a lid on increases in the recovery. She also flagged a recent study by two economists, Steven Davis of the University of Chicago and John Haltiwanger of the University of Maryland, finding that labor market flexibility had declined for years before the Great Recession, a continuing trend that could hurt economic and job growth today.
The market has been struggling for hints about Fed policy since March, when the central bank abandoned its 6.5 percent-jobless threshold for maintaining zero rates, notes Josh Feinman, chief global economist at Deutsche Asset and Wealth Management. “There is no one single number with primacy,” he says. “It’s hard to disentangle supply [factors] from demand, structural from cyclical, temporary from permanent.”
Hard, but Wall Street is trying. Economists at Barclays Capital compile an index of U.S. labor market conditions that has tended to coincide with previous rate-hiking cycles, in 1994 and 2004. The index is signaling that conditions would be ripe for the first rate increase in March 2015, earlier than the market consensus — and Barclays’s own prediction of June. The risks “are skewed to an earlier lift-off,” the bank’s chief U.S. economist, Michael Gapen, wrote in a note to clients.
Jan Hatzius, chief economist at Goldman Sachs, looks at the Kansas City Fed’s index of labor market conditions, but he contends that the best way to use it is to refer not to the long-term average but rather to the level of early 2005, the last time the economy was at full employment. By that standard, he told clients in a September 2 note, the Fed isn’t likely to raise rates until the third quarter of next year.
As if to muddy the waters further, the August employment report surprised to the downside just when most analysts were getting used to big payroll gains. Nonfarm payrolls grew by just 142,000 in the month, well below consensus estimates for a rise of around 230,000, but the unemployment rate dropped by a tenth of a point, to 6.1 percent, thanks to a modest drop in the participation rate. Monthly numbers can be volatile, of course, and few analysts were revising their medium-term forecasts on the basis of the latest data, but the figures tended to underscore the subpar nature of the recovery.
Yellen remains a dove, barring any evidence to the contrary from Jackson Hole, according to Paul McCulley, chief economist at Pacific Investment Management Co. She and William Dudley, president of the New York Federal Reserve, remain more concerned about the potential fragility of the recovery and what they believe to be a still-large pool of discouraged workers than about any incipient threat of inflation, he says. “They want a very long economic expansion,” McCulley tells II. “Yellen’s signature theme is that, after 30 years of fighting inflation and having achieved victory, labor should enjoy the fruits of the economy’s productivity growth.”
While economists debate the medium-term outlook for U.S. jobs and rates, for now the Treasury market appears ruled more by developments in Europe than at home. With the euro area economy stalling and inflation falling to 0.3 percent in August, yields on Germany’s benchmark ten-year government bond plunged by nearly 30 basis points to end the month at just 0.89 percent. That helped pull the U.S. ten-year yield down by 21 basis points, to 2.34 percent.
The real news at Jackson Hole came from European Central Bank president Mario Draghi, who said that the ECB “will use all the available instruments needed to ensure price stability.” He backed that up at the ECB’s early September meeting, cutting the refinancing rate by 10 basis points, to 0.05 percent, and announcing that the bank will begin buying asset-backed securities and covered bonds this fall. Draghi indicated that the purchases would be sizable — on the order of €1 trillion ($1.3 trillion) — but they would only restore the ECB’s balance sheet to the size of two years ago. The central bank balked at full-fledged quantitative easing, reflecting opposition in Berlin, where officials fear government bond purchases by the ECB would end any hope of fiscal discipline in Europe. “I don’t think ECB monetary policy has the instruments to fight deflation, to be quite frank,” Finance Minister Wolfgang Schäuble said in a television interview. The decision to launch an ABS program was controversial even inside the ECB, with Draghi acknowledging that the move did not enjoy unanimous support on the central bank’s governing council.
The ECB move had little impact on Germany’s benchmark government bond yields, which are already at rock-bottom levels. It did knock the euro back below $1.30 for the first time in 14 months, which could help euro area growth through the export channel. Yet few analysts believe the latest measures will overcome the headwinds facing the economy or stave off the threat of deflation in the euro area. The market is betting on more from super Mario eventually. “They will ultimately be dragged kicking and screaming to some kind of ?QE program,” says Deutsche’s Feinman.
