Download The `Whites of Their Eyes`: The Fed`s Changing Reaction Function

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May 2014
Your Global Investment Authority
The ‘Whites of Their Eyes’:
The Fed’s Changing Reaction
Function
Scott A. Mather
Deputy CIO and Managing Director
Head of Global Portfolio Management
David Fisher, CFA
Executive Vice President
Product Manager
How healthy is the U.S. labor market? Economists can’t seem
to agree. Some argue it has regained much of its pre-crisis
strength, citing the significant drop in the unemployment
rate, the relatively low number of “short-term” unemployed
and the recent acceleration in wage growth. Others say it
remains in the doldrums, suggesting that the unemployment
rate has fallen mostly because workers have left the labor
force, and that the large number of “discouraged,”
underemployed and “long-term” unemployed workers – as
well as the still-anemic pace of wage growth – indicates
substantial labor market slack.
While the unemployment rate has historically been one of the Federal Reserve’s
key measures of spare capacity, and thus inflation risk, those eagerly awaiting
each month’s employment report for signals on the Fed’s likely response may be
barking up the wrong tree. Why? The answer lies in the debate itself: Precisely
because there are so many conflicting signals coming out of the labor market,
the Fed’s reaction function may have changed. Though it will continue to
monitor a combination of employment and price signals – Chairman Yellen’s
employment “dashboard” – the Fed seems to have shifted its focus to inflation.
In other words, the Federal Open Market Committee (FOMC) may have decided
to follow the advice given to militia men at the Battle of Bunker Hill: “Don’t fire
until you see the whites of their eyes.” Rather than hike rates preemptively
based on forward-looking indicators of inflation, the Fed plans to hold onto its
policy bullets until it sees wage growth and inflation back at more “normal”
levels.
The participation rate conundrum
The participation rate measures the percent of the population that is in the labor
force – that is, people who either have a job or are unemployed but actively
looking for a job. Historically, the unemployment rate and the participation rate
have had an inverse relationship; as one goes up, the other tends to go down.
The intuition is that a tight labor market both lowers the unemployment rate (as
more of the unemployed find jobs) and entices otherwise discouraged people –
and perhaps a stay-at-home parent or two – to look for work. The conundrum is
that the participation rate, which dropped quite sharply during the financial
crisis, has continued to fall in subsequent years, even as the unemployment rate
has steadily declined (Figure 1). If the falling unemployment rate is a sign of a
strong labor market, then why is the participation rate not rising?
FIGURE 1: PARTICIPATION BREAKDOWN
11
68
10
67
9
8
66
7
??
65
6
5
64
4
63
3
2
Participation Rate (lhs)
Dec-13
Jun-12
Jun-09
Dec-10
Jun-06
Dec-07
Jun-03
Dec-04
Jun-00
Dec-01
Dec-98
Jun-97
Dec-95
Jun-94
Jun-91
Dec-92
Jun-88
Dec-89
Jun-85
Dec-86
Dec-83
62
Unemployment Rate (rhs)
Source: Bureau of Labor of Statistics; PIMCO
There are essentially two competing responses. Employment “bears” argue that
the unemployment rate is falling in part because workers are becoming
discouraged by the bleak job outlook. When a worker stops looking for a job he
is no longer counted as unemployed because he is deemed to have fallen out of
the labor force, resulting in a drop in both the unemployment rate and the
participation rate. Hence, the bears believe the declining unemployment rate is
really a sign that the labor market is so bad that workers are simply losing hope.
Bulls, on the other hand, argue that lower participation is structural and related
to the aging of the population. Since participation rates tend to be lower among
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those over 65, as this group grows as a percentage of the population the
participation rate declines naturally. Indeed, the data show a substantial increase
in the percent of the population aged 65+ in recent years, from 15.5% in 2005
to nearly 18% today (Figure 2).
15.0%
25 to 64 (lhs)
Percent of population
65.0%
Jan-14
15.5%
Jul-12
65.5%
Jan-11
16.0%
Jul-09
66.0%
Jan-08
16.5%
Jul-06
66.5%
Jan-05
17.0%
Jul-03
67.0%
Jul-00
17.5%
Jan-02
67.5%
Jul-97
18.0%
Jan-99
68.0%
Jul-94
18.5%
Jan-96
68.5%
Jul-91
19.0%
Jan-93
69.0%
Jan-90
Percent of population
FIGURE 2: GETTING OLDER, FASTER
65+ (rhs)
Source: Bureau of Labor of Statistics; PIMCO
So who's right? The truth lies somewhere in the middle. Changing
demographics have certainly added a structural element to the decline in the
participation rate over the past decade, but they don’t explain the whole story.
Since 1997, demographic shifts have been responsible for nearly two percentage
points of the decline in the participation rate (Figure 3). Interestingly, however,
approximately half of this impact had already occurred by 2008. The upshot is
that of the three-percentage-point decline in the participation rate since 2008,
only one-third can be explained by demographics. The remainder, or two
percentage points, reflects declining participation that is due to other factors.
The bulls would be quick to point out that increasing numbers of workers have
been filing for disability in recent years, and this may indeed be part of the
explanation. Bears, by contrast, would highlight the still-elevated numbers of
Americans who say they are working part-time for economic reasons or that
they would like a job even though they are not looking for one (and are thus not
counted among the unemployed). The bottom line: It seems clear that the
participation rate has been and will continue to be affected by demographics,
but there appear to be additional, more cyclical, factors contributing to its
decline in recent years.
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FIGURE 3: FALLING PARTICIPATION: MORE THAN JUST DEMOGRAPHICS
68.0%
67.0%
66.0%
65.0%
64.0%
63.0%
62.0%
61.0%
Part Rate
Mar-12
May-13
Jan-11
Nov-09
Jul-07
Sep-08
May-06
Jan-04
Mar-05
Nov-02
Jul-00
Sep-01
Mar-98
May-99
Jan-97
Sep-94
Nov-95
Jul-93
May-92
Jan-90
Mar-91
60.0%
Part Rate (constant 1997 demographics)
Source: Bureau of Labor of Statistics; PIMCO
The debate matters, of course, because of the participation rate’s impact on
wages. If the participation rate is low for structural reasons, then there may not
be lots of “excess” workers waiting until the labor market strengthens to return
to the labor force; any increase in demand for labor could thus result in higher
wages. If it's low simply because the job market is poor (i.e., for more cyclical
reasons), then it follows that an improving job market will bring some of these
previously discouraged workers off the sidelines to compete for jobs; in this case
wages might remain stable despite increasing demand for workers.
Short- versus long-term unemployment
When it comes to wage pressures, there is a similar disagreement between those
who argue that short-term unemployment matters more than long-term and
those who believe the distinction doesn’t matter. The debate has arisen partly
because the rates of short- and long-term unemployment, which have
historically moved in lock step, have diverged in recent years: The long-term rate
has remained stubbornly high, while the short-term rate has returned to precrisis levels (Figure 4). Some argue that the divergence is structural and reflects
the fact that the long-term unemployed – who have been out of a job for more
than six months – are less likely to have the skills required to compete for any
given job that becomes available. Fed Chair Janet Yellen, on the other hand, has
said that she believes the unusually high level of long-term unemployment is
essentially cyclical in nature, and a recent Fed paper argued that there is no
appreciable difference between the effects of long- and short-term
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unemployment on inflation. Why does it matter? If short-term unemployment is
what drives wages, then we can expect wage growth to return to pre-crisis levels
in short order. If long-term unemployment matters just as much, then wages
may not see much upward pressure just yet.
5.0%
7.5%
4.0%
6.5%
3.0%
5.5%
2.0%
4.5%
1.0%
3.5%
0.0%
Jan-90
Apr-91
Jul-92
Oct-93
Jan-95
Apr-96
Jul-97
Oct-98
Jan-00
Apr-01
Jul-02
Oct-03
Jan-05
Apr-06
Jul-07
Oct-08
Jan-10
Apr-11
Jul-12
Oct-13
8.5%
Long-term
Short-term
FIGURE 4: THE LONG AND THE SHORT OF IT
Short-term unemployment (lhs)
Long-term unemployment (rhs)
Average - 1990-2007
Source: Bureau of Labor of Statistics; PIMCO
The real question, however, is whether any of these debates about the internal
dynamics of the labor market really matter anymore when it comes to predicting
Fed policy. While the central bank still attempts to estimate the natural rate of
unemployment (also called the NAIRU, or the level of unemployment at which
inflation may begin to accelerate), the conflicting signals from the labor market
have clearly made the Fed less willing to trust its models. The result: Though it
may still monitor a combination of employment and inflation signals, the Fed has
decided that inflation is what really matters.
A shift in the reaction function
In Fed Chair Yellen’s February testimony before Congress, she suggested that
the decline in the unemployment rate did not tell the whole story and thus called
into question the value of the Fed’s 6.5% unemployment rate “threshold” as a
policy indicator. At the March Fed meeting, the unemployment threshold was
ditched completely. Most recently, the Fed has even suggested that it may pay
just as much attention to actual inflation as it does expected inflation.
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The Fed’s changing reaction function has two main implications for investors.
The first is that rates are likely to stay on hold until the personal consumption
expenditures (PCE) deflator (currently just over 1%) moves decisively toward the
Fed’s 2% target. In a developed economy like the U.S., price inflation usually
comes with wage inflation, so as the minutes of the March FOMC meeting
suggested, the committee is likely to pay particularly close attention to wages.
Investors should do the same.
The second is that the Fed is less likely to be proactive. This is partly because it
has less faith in its ability to forecast inflation, but – somewhat ironically – also
because it has gained a great deal of credibility by winning the war on inflation.
Not only can it wait for clear signs of inflation before hiking rates, but its
destination – the long-term equilibrium fed funds rate – may be closer to 2%
than 4%. So the Fed will wait to see the whites of inflation’s eyes before
shooting, but the market’s faith in it means that even when it does start
shooting, it may need to let very few bullets fly. FOMC members may not have
reached the vaunted status of Bunker Hill’s sure-shot militiamen, but being
veterans of a successful multi-decade war on inflation expectations has its
privileges.
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Biographies
Mr. Mather is a Deputy CIO and a managing director in the Newport Beach office and head of
global portfolio management. Previously, he led portfolio management in Europe, managed
euro and pan-European portfolios and worked closely with many Allianz-related companies.
He also served as a managing director of Allianz Global Investors KAG. Prior to these roles, Mr.
Mather co-headed PIMCO's mortgage- and asset-backed securities team. Prior to joining
PIMCO in 1998, he was a fixed income trader specializing in mortgage-backed securities at
Goldman Sachs in New York. He has 19 years of investment experience and holds a master's
degree in engineering, as well as undergraduate degrees, from the University of Pennsylvania.
Mr. Fisher is an executive vice president and product manager in the Newport Beach office,
responsible for traditional global fixed income and currency products as well as the Global
Advantage Strategy. Prior to joining PIMCO in 2008, he was a managing director and head of
global fixed income at Halbis, the asset management arm of HSBC. He previously worked as a
global bond portfolio manager at Credit Suisse Asset Management and Fischer Francis Trees &
Watts. He has 22 years of investment experience and holds an undergraduate degree in Asian
history from Princeton.
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