In the Nation's Interest

The Employment / Monetary Policy Soap Opera Continues

The markets’ fixation on the employment situation and monetary policy has become its own problem.  You might think that we all could look at the reality and chill just a bit.  The economy is improving, however gradually, and at some point in the future even a Federal Reserve that is sensitive to the fallout from the financial crisis will have to begin to reverse today’s extraordinarily easy monetary policy.  But no; the markets are hanging on every data point, and hyperventilating over every economic release that hints at change in the monetary posture.

A couple of things are going on.  One is that the markets are looking out for the markets, not for the economy as a whole.  So good news for the economy may be bad news for the markets.

And how can that be?  Well, markets are always searching for ways to profit, and for the past seven years that has included profiting from extraordinarily low interest rates.  A recent McKinsey Global Institute report demonstrated that there has been little or no aggregate deleveraging since the onset of the financial crisis.  Since the end of 2007, aggregate global debt has increased by $57 trillion (from $142 trillion to $199 trillion), or by 17 percent of global GDP (from 269 percent to 286 percent).  Much of that added debt is in the public sector, arising from the budgetary hit of the crisis and the need for stimulus.  And much of it is concentrated in just a few countries.  The financial sector itself has deleveraged most, followed by the household sector.  But the aggregate figures raise the question (as was highlighted in a recent private conversation with CED member Joe Kasputys):  How are the heavily indebted entities going to be able to manage the hit when interest rates do go up?  And note that those rising interest rates will increase debt service costs at the margin by orders of magnitude.  This concern is in addition to the fears of some market participants who have borrowed at variable rates and lent at fixed rates, and will take their own hit when rates finally do rise.  Plus, higher interest rates will entice many household investors back out of equities and into safer assets, cutting off profit in the equity segment of the financial industry.

So the Federal Open Market Committee (FOMC), as the focus of all of this scrutiny in such an anxious market, has had to judiciously begin to signal the possibility that it will consider the need to initiate the process of deliberation on the choice of the appropriate initial steps to set in motion a train of events that will eventually lead to a determination that it is a fitting time to discuss, well, raising interest rates.  Patiently.  The markets went into cardiac arrest when the newly appointed Fed Chair got a little too close to specificity on that chain of events, in her first (with all respect to a friend I might even say “rookie”) press conference – two years ago.  And the markets haven’t calmed down since.

So the financial markets are fixated on the Federal Reserve; and the Fed has made clear that it is focused on the labor market.  Hence, the monthly employment situation report has become a fetish of the financial markets, by the transitive property that we all learned in high school algebra class.  And because the financial markets fear above all else Fed action to raise interest rates, a strong employment report is bad news.  Good news is bad news, and after all that we have been through in this dreadfully languid recovery from a dreadfully deep recession, that is hard to swallow.

The March employment report, being bad news, was therefore good news.  It led investors to believe that Fed action will be later than was previously anticipated.  This was on the heels of more-robust January and February reports that had investors fearing Fed action sooner rather than later.

I’d like to try to provide simultaneous translation of both sides of this near-hysterical dialog between the labor markets and the financial markets.  Let’s start with the March jobs report.

On the surface, the March employment situation report signaled renewed weakness.  Payroll employment increased by only 126,000 jobs, well below the 200,000-plus pace to which we had become accustomed over the previous 12 months (average job growth from March of 2014 through February of 2015 was almost 270,000).  And while they were at it, the killjoys at the BLS revised downward the job growth from January and February by a combined 69,000.  The household survey showed a 130,000 drop in employment, and the unemployment rate remained constant only because the survey had 96,000 persons dropping out of the labor force.  The labor force participation rate fell by 0.1 percent, to 63.0 percent – a level just two-tenths of a percentage point above its nadir of the last 37 years.

No, it did not look good.  But in the end, I believe that many analysts are over-interpreting the apparently weak March report, just as they were over-interpreting the apparently strong January and February reports.  There are at least two good reasons why the March numbers probably overstate any current weakness in the economy.

Reason number one is the weather.  Yes, it is always raining (or snowing) somewhere.  But March was an extension of a dismal winter in several parts of the country (I’m talking about you, Boston), which put a real damper – pardon the pun – on economic activity.  Some of those losses surely will be made up in subsequent months and quarters.

Second, there were jobs lost in oil and gas, showing up in the mining industry category.  Given the very low market price of oil, there is less U.S. exploration going on, although many existing wells continue to be profitable to operate – hence the glut.  Those lost jobs, as well as the reduced revenue of producers, is a hit to our economy.  But given our consumption of imported oil, which remains substantial, most analysts believe that the lower oil prices remain a net plus for our economy as a whole.  Evidence is that consumers still hold on to a goodly share of their savings, and households surely are chastened by their losses in the financial crisis.  But longstanding wisdom remains that you should not underestimate the ability of the American consumer to consume; and that money surely will find its way out of those pockets sooner or later, once balance sheets have been replenished to their satisfaction.

We should always look at a single month of data with caution.  All sorts of odd things can happen, even with a large data sample.  We are coming off of an extended period of reasonably healthy growth, which should carry some momentum.  And even though we all are healthy until we are sick, it seems way too early to suggest that some as-yet-unidentified problem has beset the labor market and the economy.  My money is on a stronger-looking employment situation report next month.

Which takes us back around to the Federal Reserve.  How do we expect the Fed to react to the rather mashed signals in the March jobs report?

Well, first of all, I do expect that the Fed is predisposed to average out the somewhat weaker March report with the somewhat stronger reports from the preceding months, and estimate a central tendency of more or less steady as we go.  And that suggests no dramatic movements of the controls in the near term.  But beyond that, I believe that the Fed is further predisposed to touch the brake pedal only with caution, for reasons that go far beyond the possibility of a few moments of palpitations of the hearts of financial market players.  For this prognostication I would offer three reasons.

Centrally, this economy is not inflation-prone – in fact, far from it.  We are swimming in supply – and swimming in oil is only a part of it.  Virtually every market is crowded with sellers who are willing to bid for the picky consumer’s dollar.  The ease of entry into foreign (read our) markets, and the ability to search on line for prices and product attributes, both help to drive prices down.  Some have argued for half a dozen years that the Fed’s monetary stimulus was about to cause instantaneous inflation and a plunging dollar.  They have been proven wrong – for the relevant future, at least – and a large part of the reason has been the intensity of competition.  Sellers have no pricing power, and frankly they just don’t care what some economic theorists say about the quantity of money.

Second, the housing sector – which has been the driver of past economic recoveries – remains dormant.  There is of course plenty of institutional history such that we must read this point with caution.  In the good old days of Regulation Q and savings and loan institutions, housing took 100 percent of the first-round hit of restrictive monetary policy, and correspondingly provided 100 percent of the rebound when monetary policy eased.  Those days are long gone.  But housing was the first-round and major source of the economic downturn that followed on the financial crisis, and housing remains soggy.  Consumers clearly are gun-shy following the hits that they took on their balance sheets or even in their daily lives during the crisis.  Assessing the housing market now, when there remains an unconventional source of supply in the large number of vacant units potentially for sale, is very difficult.  Compounding that is the enormous geographical diversity in the depth of the crisis, plus the geographical variation in current overall economic growth with the boom and coming bust in the oil patch, plus some hollowed out urban cores in the shadow of other vibrant cities.  But, bottom line, it is hard to imagine this expansion looking like it will burst at the seams without a big step-up in housing activity, and that does not appear to be happening anytime soon.

Finally, and the subject of constant public conversation and past CED monthly calls, we have a large number of working-age adults outside of the labor force – a seeming analog to the large number of vacant houses potentially on the market.  Will those labor-force dropouts come back in as job opportunities begin to reemerge and wage offers begin to rise?  I won’t rehash past discussions, but this is a big, big question.

The Fed has – appropriately, in my view – remained cautious about stating its plans.  It says that it will be – and again in my view, it should be – data-driven.  But it has also hinted that it will behave somewhat differently going forward than it has in the past.  Having stepped through the zero lower bound – like Alice stepping through the looking glass – it sees a different world that requires different choices.  Here are a couple of the important new tools and techniques that you should look for.

In typical past unwindings of stimulative monetary policy, the Fed has picked the right moment to begin, increased the Federal funds rate by one-quarter of one percentage point at that meeting, and then proceeded to increase the funds rate again by that same quarter point at each meeting, eight meetings per year, with the regularity of the beat of a Sousa march.  Any departure from the rhythm would be taken to be a signal of something extraordinary going on; perhaps the Sousa march was “The Stars and Stripes – Forever.”

This time around, however, the Fed already has begun to signal that it very well might not raise the funds rate at every meeting.  In keeping with the concerns about the economy just mentioned – the uncertainty of the recovery, weak housing, inflation below the target range – the Fed wants the markets to understand that it will continue to be data-driven, even after it determines to begin to raise the funds rate.  The Fed wants the markets to be aware of that mindset, so that market players do not assume from a blank month after tightening begins that the Fed has seen reason to panic.  It is an important part of an overall message that the Fed is trying to send, that it recognizes that these are extraordinary economic times, and that it must keep its eyes and ears open and its feet bouncing like a tennis player waiting for a serve that could go to either the forehand or the backhand side and with unpredictable spin and pace.  I think that this is exactly the right approach for the Fed, and hope that the Fed’s communication will be heard.

There is a second potential tool in this return from the unfortunate side of the zero lower bound.  The Fed, as you know, has substantially expanded its balance sheet, and holds substantial amounts of securities of various types.  The presumption on the part of many would be that job one in unwinding the Fed easing would be to bring the balance sheet back down to a “normal” level, relative to the size of the economy.  However, some have argued that the Fed could fine-tune its future monetary policy, even with the economy much closer to full utilization, if it retained manipulation of its balance sheet as a potential tool.

As an example, some worry that the United States far overdoes investment in housing relative to what would be best for the economy.  Partly, this is a question of inertia, starting from the traditional role of home ownership in the “American Dream.”  Partly, however, it arises from the apparent security and ease of valuation of mortgages as assets for trade and collateralization; it is simply easy for banks to take mortgage loans equal to a fraction of the recently traded value of a home insured against hazards as a bedrock asset upon which to build its portfolio.  This encourages too much of our nation’s stock of scarce capital to flow into housing, these experts would argue, instead of going into business assets that arguably would contribute more to future economic growth.

These experts would suggest that the Fed should keep on its balance sheet some amount of mortgage-backed securities.  Then, when it comes time for the Fed to tighten, it could do so by raising the Federal funds rate, per usual, or alternatively it could do so by selling mortgage-backed securities from its portfolio.  This would concentrate some of the downward pressure of monetary policy on the housing sector, rather than allowing it to spread more broadly across the economy.

I’m not sure what I think of the idea.  It is a little hard for an economist who has always relied on markets to contemplate tinkering with the allocation of resources.  Sure, there is a reasonable argument that the market is underpricing, and therefore overallocating resources to, housing.  But I would be much more comfortable if we weren’t groping in the dark to find what the price of housing really should be.  And if we believe that we are overspending on housing all of the time, I’m not quite sure why disproportionately hitting housing during economic downturns would result in a more reasonable allocation of resources over the long term.  The disproportionate hit on housing in downturns during the Regulation Q days did not stop our economy from overinvesting in housing over the steady state.

There is a third potential change in Fed procedures that may be worth watching for.  We still talk about raising the Federal funds rate as shorthand, but in the near term, the overnight funds market so awash in liquidity that traditional open market operations would not work.  Instead, the Fed will use an alternative tool, which is to increase the interest rate that it pays on excess reserves.  In effect, the market price of very-short-term funds will be the Fed’s rate on excess reserves, because lenders who cannot get that rate in the market will simply park their money at the Fed.  This is more an operational than a strategic issue, but the need to reach for a new tool from the toolbox is just one more indication of this new and strange time in which we live.

So in summary, if bad news is good news, and good news is bad news, what is no news?  I don’t see any significant change in direction coming from the March employment situation report, and I doubt that the Fed did either.  What is happening behind the curtain is that the Fed is trying to find new ways to communicate as openly and transparently as possible the fact that it has not yet made up its collective mind, and that it must look at incoming data before it can make its decisions.  And meanwhile, the Fed is searching for new ways to pull the levers and turn the gears to achieve the outcomes that it wants.  This is a fascinating world to watch.  I just wish it were a more prosperous one as well.