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Monday, July 18, 2005

Fed Watch: On Track for More Tightening

Tim Duy brings us another Fed Watch.  I enjoy presenting these because it’s nice to get a perspective that sometimes differs from my own:

For the time being, the US economy looks firm enough to trigger additional Fed tightening.  The economy is growing moderately with subdued price pressures under a policy of measured rate hikes.  Sounds like policy, then, is just about right.  If it isn’t broke, don’t fix it.

The recent spate of data has been anything but positive from a growth perspective.  On the demand side, the retail sales report tells us that the American consumer remains in an acquisitive mood, even excluding autos.  The ISM survey showed an uptick in manufacturing activity, silencing, at least temporarily, those analysts who noted that the Fed never hikes rates when the ISM falls below 50.  And Friday, the Fed released a strong industrial production report for June, reporting a 0.9% increase in headline IP, a capex rate of 80%, and strong gains in business equipment production.

Benign readings on inflation suggest that inflation has leveled off and may possibly be falling. This could be interpreted as a signal that the Fed’s job is almost done – vanquishing the inflation dragon is after all a monetary policy maker’s chief objective.  An alternative view, and the one that I think will hold sway on Constitution Avenue, is that controlled price pressures is a signal that the Fed’s policy path is working. 

Indeed, Fedspeak, including today’s Greenspan comments, and comments by Fed Bank presidents (thanks to Mark Thoma and David Altig) suggest that policymakers are comfortable with economic activity and the path of policy.  Indeed, altogether it is not surprising that the markets are looking for a Fed Funds rate of 3.75% by October.  More could still be coming as well; the yield on the 10 year Treasury is up to 4.2%, reducing the risk of a yield curve inversion for the time being (Not that Greenspan appears particularly worried about it in any event.  Perhaps he read David Altig’s piece.)

For more on the underlying strength of the economy, see today’s Wall Street Journal for an article that partially attempts to dispel the myth of the declining US manufacturing sector (subscription). This article is sure to unsettle those who focus on the decline in manufacturing jobs (a trend that, as a share of total payrolls, began during WWII, long before most Americans could find China on the map). From the Fed’s perspective, however, I suspect it will be viewed as support for the notion that manufacturing payroll weakness is structural, not cyclical, and likely outside their purview.

Which leads us into a growing criticism of Fed policy, the labor market.  Many point to the relatively tepid job growth numbers and the drop in labor force participation rates, regardless of the unemployment rate, as evidence of a weak labor markets – weak enough that the Fed errs by continuing its tightening campaign.  In Monday’s New York Times, Paul Krugman, following the research of Fed Boston economist Katherine Bradbury, suggests that there is considerable slack in the labor market.  This slack, as much as 3.3 percentage points, is the result of persons not reentering the labor force as quickly as in past recoveries, and thus not counted as unemployed.

Krugman acts as if some great mystery has been revealed to him.  Perhaps he never gets to Table A-12 in the employment report, alternative measures of unemployment.  This is not some hidden conspiracy; if you widen the definition of the labor force, you will increase the unemployment rate.  You can narrow the definition as well, to only those unemployed 15 weeks or longer (a 1.6% unemployment rate).  That the labor force participation rate has fallen, and thus measured unemployment has fallen, is simply not new news.  I teach it multiple times a year.

Krugman also implies that the decline in labor force participation is largely cyclical, and that Fed officials are dropping the ball by hiking rates.  Bradbury herself is more cautious on the former point:

“To the extent that explanations for this sub-normal participation are cyclical…”

“Note that the analysis in this brief represents a simple descriptive exercise, not a modeling of participation behavior.”

“…it seems likely that part of the below average participation rebound for women in this cycle reflects a secular downshift in women’s participation rather than a cyclical response…”

In other words, secular and structural issues are at play.  You may have chosen to participate in household production. And just because you may want a job, doesn’t mean you have the skills that current employers want.

This latter part, the possibility of structural unemployment and withdrawal from the labor force, is what troubles me about the slackness in the labor market story.  You may think you have available workers, but you really don’t.  I suspect that Fed officials will be cautious in this regard as well (think again to structural unemployment in manufacturing).  For example, in the course of my duties, I speak with executives from a wide swath of Oregon firms.  I hear a common complaint – good workers are simply hard to come by.  This in a state with a relatively high unemployment rate!  One firm owner said his concerns are not simply finding someone who can swing a hammer, it is a lack of workers across the skill spectrum.

What about the lower end of the labor market?  Isn’t this a natural place for marginally attached workers to end up?  Interestingly, a local temporary help agency reported to me that in a recent month, they rejected a stunning 90% of applicants for three reasons: 1.) Lack of previous employment experience (note here that Oregon has the second highest minimum wage in the nation), 2.) Felony conviction in the past 7 years, and 3.) Failure to pass a drug test (effectively required unless you want to see your worker comp rates shoot through the roof). You might want to work, but if no one wants you even when they need workers, you really aren’t available and do not represent slack.

None of this is meant to detract form Katharine Bradbury’s dissection of the labor force participation rates. Instead, it is meant to imply that Fed officials will be much more cautious than Krugman in their interpretation of her work.  There may be slackness in the labor market, but how much is an open question, and Fed officials will be wary of finding the answer by waiting for inflation to tell them. 

    Posted by on Monday, July 18, 2005 at 04:05 PM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (0)  Comments (9)


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