Williams v Summers: Half Full or Half Empty?

SF Federal Reserve President Williams last night delivered an interesting speech with the provocative title, Whither Inflation Targeting? A good portion of his speech echoed comments he made a few weeks ago, in Monetary Policy in a Low R-star World -- namely that the Fed could better fulfill its mandate under a modified monetary regime. But some of his comments pertained to the current policy decision and are worth considering further.

Williams starts by addressing employment, noting "a very strong labor market by any standard." Turning to inflation, he notes, "We’re not quite at our target yet, but the combination of fading transitory factors and a strong economy should help us get back to our 2 percent goal in the next year or two." In light of these views, Williams addresses the implication for rate policy, concluding, "...it makes sense to get back to a pace of gradual rate increases, preferably sooner rather than later."

Contrast this with the views Larry Summers included in his comments yesterday. On employment, Summers noted, "Private sector GDP growth for the last year has averaged 1.3 percent a level that has since the 1960s always presaged recession." He continued, "Total work hours have over the last 6 months grown at nearly their slowest rate since early 2010." (I addressed this point in Is the US Near Maximum Employment?) As for inflation, Summers observed, "both market and survey measures of inflation expectations continue to decline."

What accounts for the discrepancy between the views of Williams and Summers? Is this simply a case of the glass being half full or half empty depending on one's perspective?

I believe the divergence in views can be explained in part by the divergence in their motives. As a current FOMC member, Williams shares Yellen's concern that the FOMC may not have sufficient room to reduce the IOER in response to the next recession, in which case the Fed would be subject to political pressure to expand the policy toolkit to include less traditional tools, such as negative interest rates and an expansion of assets available for purchase as part of the Fed's large scale asset purchase program. As we've discussed, various FOMC members appear uncomfortable with such tools -- hence the debate over the existing policy toolkit.

In contrast, I suspect Summers' best prospect for replacing Yellen as Fed Chair when her term expires in February 2018 is for the Fed to come under political pressure , without which there would be political pressure for Yellen's reappointment. More specifically, the Democratic party has moved considerably to the left since Summers was Treasury Secretary, and Summers needs to overcome critics such as Elizabeth Warren, who openly supported Yellen over Summers when the job was last available in 2013. By aggressively advocating a more dovish policy than Yellen, Summers may be positioning himself as an acceptable alternative to Yellen when the job is next available.

To be fair to both men, I suspect both genuinely believe in their respective positions. But people have a tendency to choose their beliefs to suit their interests, and I suspect Williams and Summers are as susceptible to this influence as are the rest of us.

Implications

The current incumbents on the FOMC have an interest in raising the policy rate ahead of the next recession to a level that would allow them to mount a sufficient response to the next recession with a combination of lower but positive IOER rates, forward guidance, and perhaps a modest increase in quantitative easing. As a result, I believe they'll make every effort to increase the IOER whenever the data permits -- and this includes financial market data (ie, asset prices). While I suspect the won't be able to hike as much as implied by the latest dot plot (or Yellens' fan chart), I imagine they will be able to hike more quickly than suggested by current market pricing -- particularly with the Oct16 Fed Funds futures contract currently at 99.565.

But in addition to the usual schism between hawks and doves, we're now seeing an increasingly active debate regarding the strategies and tactics with which the Fed pursues its mandate. On one side we have Yellen and David Reifschneider, deputy director of the division of research and statistics at the Board of Governors, who believe the Fed can continue targeting an inflation rate of 2% with its available tools. On the other hand, we have Williams, Olivier Blanchard, and others who believe the Fed should adopt a new strategy (such as a 4% inflation target or a switch to targeting nominal GDP) -- or at a minimum believe the Fed requires new tools, such as negative interest rates, in order to successfully pursue its objectives.

The problem for the market is the uncertainty that this open debate engenders. Williams argues that now is the the time to reconsider these strategies and tactics, given the current performance of the economy. But the market is facing considerable uncertainties already, including a change of administration in the US, Brexit, a constitutional referendum in Italy this November, elections in Germany and France next year, and a review of monetary policy In Japan.

As seen in the graph below, volatility in the rates and equity markets is already low by historical standards. It's difficult to see volatility remaining this low given the events on the calendar -- let alone a reappraisal and reimplementation of monetary policy strategies and tools at the Fed. My sense is that the growing debate over monetary policy at the Fed -- and elsewhere -- will only add to financial market volatility in coming quarters.

Is the US Near Maximum Employment?

Many of the recent comments from FOMC members suggest a desire to increase the IOER by another 25 bp before the end of the year, given favorable developments in the US labor market and recent progress in returning the inflation rate to the 2% goal.

The statistic most frequently cited to support the view that the labor market is near full employment (or maximum employment, as specified by the Federal Reserve Act), is the unemployment rate, currently at 4.9%. And as shown in the graph below, this rate appears consistent with the notion that that US employment is fairly 'full', even if it's not reached a maximum.

On the other hand, skeptics often note that the labor force participation rate has been declining, to 62.8% currently, down from 67.3% in the first half of 2000, suggesting a pool of available labor may be available to rejoin the labor force in the event labor demand increases further.

This last argument is often rebutted by referring to demographic changes over time, primarily those relating to age and gender given the post-war demographic bulge and the trend increase in the female participation rate throughout the latter half of the 20th century.

In an attempt to control for these changes, we show the percentage of men aged 25 to 54 who were employed over time (determined by combining various series from the Bureau of Labor Statistics).

There are three points particularly worth noting in this graph:

1. The much-discussed downward trend is clear.
2. The percentage dropped precipitously at the start of the last recession but has been increasing fairly steadily in recent years.
3. Despite the recent increase, the figure still has not recovered to the lowest point in any cycle shown -- in nearly 70 years of data.

The reported unemployment rate for this demographic is currently 3.9% -- precisely the average figure for the third quarter of 1988, when Reagan was finishing his second term. But in contrast, the percentage of men aged 25 to 54 who were employed average 89.6 in the third quarter of 1988, while the comparable figure at the moment is 84.7%

In other words, whether we consider the labor force participation rate for the entire population, or we attempt to control for changing demographics, we get the sense that the labor force could increase in size by roughly five percentage points (ie, an increase in employment closer to 6% greater than current levels) before employment should be considered to be at 'maximum' -- at least if history is any guide.

A variety of factors appear to be contributing to these trends, but two particularly interesting aspects are cited in a recent White House discussion paper, titled The Long-term Decline in Prime-Age Male Labor Force Participation. 

The first graph below shows labor force trends by birth cohort. Note that in addition to the standard decline with age, we see a decline over time -- ie, each cohort has a lower participation rate than the previous cohort, even controlling for age.

The next graph shows participation trends by level of educational attainment. Note that while the trend has been downward for each of the three groups represented in this graph, the rate of decline is proportional to educational attainment, with the participation rate decreasing most for those with a high school education or less.

Taken together, these graphs are consistent with scenarios in which increased global competition over time among workers with less education results in wage pressures that motivate an increasing number of men in these cohorts to exit the labor force. While this interpretation also is consistent with many documented wages trends, I mean it only to be suggestive in this case, as my argument here doesn't rely on the specific mechanism responsible for the declines in labor participation rates. Rather, my argument is that the pool of available labor in the US is larger than one might infer simply by referencing the headline unemployment rate.

Of course, this argument isn't original. In fact, numerous members of the FOMC have discussed it in various speeches. For example, Governor Powell discussed this view at some length at a speech in June of this year. Governor Brainard discussed it in a speech in May. And Rosengren discussed it in a speech this April.

But if FOMC members are generally aware of these issues with the labor force participation rate, why are so many set on raising the policy rate at the moment, especially when inflation has been below target for such an extended period and when wage gains have been fairly disappointing for so many for so long?

My sense is that FOMC members are confronted with political considerations in additional to economic considerations. If FOMC members don't manage to increase the IOER much further before the onset of the next recession, members will have little scope to reduce the policy rate in response, particularly if they wish to avoid negative policy rates, as Yellen noted at Jackson Hole.

Yet FOMC members are certain to feel pressure to act forcefully during the next recession. And if there's little scope for reducing the policy rate, pressure will increase to take other measures, such as widening the scope of assets purchased as part of an expanded LSAP program. Even a forceful formulation of forward guidance would pose unwanted risks for the Fed, as Yellen outlined at Jackson Hole. And it's clear that the Fed has no intention -- or legal means -- of engaging in outright monetary financing. So engineering a material increase in the IOER would give FOMC members space to react to the next recession in a way that would soften political pressures that otherwise could be exerted.

So I expect that policy decisions will in fact be data dependent (including a dependence on financial market data). And I suspect quite a number of FOMC members otherwise would like to indulge a bias toward allowing the labor market to build strength sufficient to see an increase in real wages and perhaps even in unit labor costs. And perhaps they'll have a greater chance to indulge this tendency provided the expansion continues long enough and with enough vigor for the FOMC to increase the policy rate comfortably off the zero lower bound.

But for now, I suspect they'll increase the policy rate at a moderate pace, but with sufficient deliberation to avoid getting caught by the next recession with the rate still close to zero. More specifically, They may not manage to raise the IOER quickly enough to fulfill the expectations in the last dot plot -- or in Yellen's Jackson Hole fan chart. But I wouldn't be surprised if they managed to raise the policy rate somewhat more than is currently priced into the market, shown with the FOMC dots below. [Source: Bloomberg]