The second half of 2012 saw a significant shift in US monetary policy from calendar-based guidance to outcome-based guidance and the adoption of a 6.5% unemployment rate as a threshold for 'tapering'.
With Friday's better-than-expected payrolls data and another tick lower in the critical-to-liquidity unemployment rate, it seems Goldman Sachs (and others) are waking up to the facts that we have been vociferous about: the shift of jobless individuals from unemployment into inactivity (the participation rate dilemma) is making the unemployment rate a less appropriate measure of broad labor market conditions. This has important implications for Fed policy because it implies that the committee might still be quite far from reaching the jobs side of its mandate even once the unemployment rate is back at 6%.
After all, the Federal Reserve Act calls for 'maximum employment', not 'minimum unemployment'. This distinction did not matter much in the past, but it is becoming increasingly important. The 'participation gap' remains as big a drag on growth as 'unemployment' and we, like Goldman, would expect the Fed to 'change' its target for their outcome-based guidance (to enable moar printing).
Via Goldman Sachs,
The second half of 2012 saw a decisive shift in US monetary policy. One aspect was the move to open-ended asset purchases of $85 billion per month.
The other aspect - and our focus today - was the adoption of a 6.5% unemployment rate as a threshold for the first hike in the federal funds rate. The motivation for the move from calendar-based guidance to outcome-based guidance is simple and compelling. It is much more sensible for a central bank to guide expectations about future policy actions in terms of an economic criterion than in terms of a particular date.
But the 6.5% threshold for the unemployment rate is not an ideal outcome-based target.
The reason is that the unemployment rate is increasingly distorted by the decline in labor force participation.
Labor force participation has fallen by 2.7 percentage points since the start of the 2007-2009 recession.
Some of this decline is clearly related to the aging of the US population. Population aging shifts the composition of the over-16 population - which forms the denominator of the participation rate. The chart below shows that changes in the composition of the population account for 1.2 percentage points of the decline in labor force participation.
This decline is clearly structural, and it will continue at an estimated pace of about 0.2 percentage points per year for the foreseeable future.
Even if the participation decline is a consequence of the post-2007 downturn in labor demand, it might still have long-term effects. One specific concern is that we are now seeing a US version of the increase in European structural unemployment following the 1980-1982 recession. This increase established the term “hysteresis” - an extreme form of persistence in which a labor market shock is never reversed - in the lexicon of economics.
Most economists agree that the relatively easy availability of long-term jobless benefits was one key reason for the European hysteresis problem of the 1980s. So it is not surprising that the more pessimistic commentators on the US labor market outlook have focused on the Social Security Disability Insurance (SSDI) system as a potential analog to the European unemployment benefit issue. Since 2007, the number of SSDI disabled worker recipients has risen by 1¾ million, or 0.7% of the over-16 population.
Ignoring the participation rate is a mistake. Goldman's regression shows the unemployment rate and participation gap are of similar magnitudes when related to slowing growth - a 1pt rise in unemployment or the participation gap equals around a 0.16% YoY drop in wage growth
the shift of jobless individuals from unemployment into inactivity is making the unemployment rate a less appropriate measure of broad labor market conditions. This has important implications for Fed policy because it implies that the committee might still be quite far from reaching the jobs side of its mandate even once the unemployment rate is back at 6%. After all, the Federal Reserve Act calls for “maximum employment”, not “minimum unemployment.” This distinction did not matter much in the past, but it is becoming increasingly important.
The more immediate implication is that Fed officials may need to revisit their forward guidance. In principle, we see three options for what they might do, in increasing order of aggressiveness.
- Emphasize that 6.5% only a threshold. They could emphasize even more that the 6.5% figure is only a necessary but not sufficient condition for a hike. This is the simplest option because it does not require agreement on a new measure, but it would make forward guidance a less and less powerful instrument of monetary policy and thereby violate the principles laid out in Michael Woodford’s 2012 Jackson Hole Paper on monetary policy accommodation at the zero bound, which seem to enjoy widespread acceptance among many FOMC members.
- Change the number. They could lower the 6.5% threshold while keeping the focus on the unemployment rate. This would be a pragmatic way of adjusting the current approach for the participation issue without having to introduce new and less widely followed labor market indicators into the FOMC statement.
- Change the measure. They could directly couch their guidance in terms of the employment/population ratio (presumably adjusted for the effects of population aging), our total employment gap shown in Exhibit 8, or a participation-gap adjusted unemployment rate. This directly addresses the underlying issue, namely that the unemployment rate has become a less useful statistic. But it would be considerably more complicated in terms of communication.
Financial markets continue to expect a very late exit despite the declining unemployment rate, so Fed officials may not feel much urgency in revamping their forward guidance. But as we approach 6.5%, a reduction in the threshold or maybe even a new measure may well be necessary.