Beware the Fed

About the author:

Author name:

By Michael Knox

Job title:

Chief Economist and Director of Strategy

Date posted:

10 June 2016, 11:09 AM

The US employment figures for May that were released on 3 June 2016 took the market by surprise. Two things happened together which did not seem to make sense. The first thing was that employment increased by a much lower than anticipated 38,000 jobs for May. The second thing was that unemployment fell by 0.3% to 4.7% in May.

The market interpreted the very low employment growth number as a slump in demand for labour. Normally if there were a slump in the demand for labour, then unemployment would rise. How could unemployment have fallen? To find an explanation, we must look at two different surveys. The employment number comes from the establishment survey. The unemployment number comes from the household survey.

What the household survey showed was that the slow employment growth came not from a fall in demand for labour but instead from a fall in the supply of labour. The household survey showed that the civilian labour force actually declined by 458,000 people between April and May. This meant that the participation ratio fell by 0.2%. The number of people not in the workforce rose by a surprisingly high 668,000 people. So the employment growth was low because the supply of labour tightened. There were fewer people coming forward to look for jobs so the unemployment rate fell.

The labour market has become tighter rather than easier. This means that wages are more likely to go up than go down. When wage growth goes up, then core inflation will go up. Nowhere here is there anything that indicates the Fed is not going to tighten.

In Figure 1 above, we see the year-on-year growth rate of US payroll employment. The softness in the growth rate does not appear to be as dramatic as the monthly number might suggest. The annual employment growth rate has fallen from 1.9% in February to 1.7% in May. This takes annual employment growth down to the same level that it was for the year to December 2012. Employment growth is soft but we cannot say that it is bad.

The problem facing the Fed

When we talk to people in the market, they tend to talk about employment. When we talk to people in the Fed, they tend to talk about unemployment. In Figure 2 above, we see what we think of as the Fed's view of the world. The blue line represents the actual level of unemployment published by the US Department of Labor. The red line represents our projection of that unemployment at its current rate of decline out to 2020.

We also see two other things. The green line shows the natural rate of unemployment of 4.9%. The natural rate of unemployment is the level below which real wages start to rise. This rise in real wages then results in upward pressure on core inflation. Put simply, below the natural rate of unemployment, inflation will rise after a lag of around two quarters. This is why the natural rate of unemployment has been referred to by Janet Yellen as "full employment".

The second thing we see is the minimum level of unemployment. This is the lowest level of unemployment recorded in the US since 1990. That level of unemployment was 3.9% in April 2000. At that low level of unemployment, the level of graduate unemployment fell to a level of around 1%. This means the pool of qualified labour that could move around the US economy to increase its growth was exhausted. The result was a rapid escalation in wages. The Fed stepped in aggressively to slow the economy and a recession followed. The minimum level of unemployment reached in 2007 before the recession of 2008 was slightly higher than the minimum level of unemployment recorded in 2000.

What the Fed has to do

What the Fed has to do is to slow the growth rate of unemployment before unemployment collides with the minimum historical rate. Should the Fed not be able to slow the decline in unemployment before it collides with the minimum rate, then history tells us that a US recession will be inevitable.

In her presentation on 6 June 2016, Janet Yellen said "further increases in the Federal Funds rate are likely to be appropriate." So the Fed is telling us that it has to keep raising rates. In case you missed that, she went on to say later in the speech "I continue to think that the Federal Funds rate will probably need to rise gradually over time to ensure price stability and maximum sustainable employment in the longer run."

The natural rate of interest

Yellen then introduced the idea of the neutral rate of interest. This is also called the natural rate of interest. Yellen noted "one useful measure of the stance of policy is the deviation of the Federal Funds rate from a neutral value". She said this is defined as "the level of the Federal Funds rate that would be neither expansionary nor contractionary if the economy were operating near potential (full employment)."

She went on "at present, many estimates show the neutral rate to be quite low by historical standards - indeed, close to zero when measured in real, or inflation adjusted terms". She noted that "the current actual value of the Federal Funds rate also measured in real terms, is even lower, somewhere around 1%."

So the level of the Fed Funds rate that would stabilise the economy at full employment is 1% higher in real terms than it is now. The economy is now at full employment.

Conclusion

US employment has now fallen to a level that the Federal Reserve has described as full employment. The Chair of the Federal Reserve has just told us that the level of unemployment the real Fed Funds rate needs to go up by is 1%.

The market has convinced itself that the Fed is not going to put up interest rates.

Question: What do you think the Fed is going to do now?

Answer: They will put up the real Fed Funds rate by 1%.

More information

View more analysis by Michael Knox by clicking on 'economic strategy' in the popular topics list to the right of this page.

Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents ("Morgans") do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.