GOLDMAN: We Disagree With The Fed

Jan HatziusGoldman SachsJan Hatzius

On Wednesday, the Federal Reserve finally ended quantitative easing, one of its extraordinary monetary policy measures aimed at stimulating the economy.

It was confirmation that the days of the financial crisis are behind us and that the US economy is returning to normal.

“Labour market conditions improved somewhat further, with solid job gains and a lower unemployment rate,” the Fed said in its FOMC statement on Wednesday. “On balance, a range of labour market indicators suggests that underutilization of labour resources is gradually diminishing.”

Fed-watchers noticed a word was missing from this characterization of the labour market. Here’s what the FOMC statement read back back in September:

“…On balance, labour market conditions improved somewhat further; however, the unemployment rate is little changed and a range of labour market indicators suggests that there remains significant underutilization of labour resources…”

The exclusion of the word “significant” was no accident, and for monetary policy experts it was a signal that the labour market has improved so much that an initial interest rate hike would come sooner than later. Currently, most economists believe will come in mid-2015 give or take a few months.

“[W]e disagree with the committee’s view on labour market slack,” Goldman Sachs’ Jan Hatzius wrote in a note to clients. “While the unemployment rate is now below 6% and the explicit phrase in the FOMC statement that “…underutilization of labour resources is gradually diminishing…” is factually correct, the implicit notion that underutilization is no longer “significant” — the term used in the July and September statement — looks inconsistent with the employment and wage data.”

In his argument, Hatzius highlighted two labour market indicators: the labour force participation rate (LFPR) and the rate of involuntary part-time employment.

Here he is on the low LFPR: “Exhibit 2 shows our updated summary of recent studies that attempt to split the drop in the labour force participation rate since 2007 into structural and cyclical factors. The median study finds that structural forces have lowered participation by 1.6 percentage points and cyclical forces have contributed another 1.1 percentage points.2 When translated from a share of the over-16 population to a share of the labour force, this 1.1-point number is equivalent to about 1.6 percentage points. Even if we assume that the gap has shrunk a bit since the publication of the median study in the table, the results suggest that depressed labour force participation remains a very important factor in evaluating slack.”

Here he is on the elevated level of involuntary part-time employment: “Exhibit 3 shows that the share of workers who report themselves part-time employed for economic reasons, either because their hours were cut back by their employer or because they could only find part-time work. This share remains about 1 1⁄2 percentage points above the pre-crisis norm. This is equivalent to an additional 3⁄4 percentage point when translated into full-time equivalent hours, recognising that part-timers average about half the hours of full-timers.”

This slack in the labour market would explain the persistently low rate of wage growth.

“Partly for this reason, we expect core PCE inflation to remain at 1 1⁄2% in 2015, which we think would be enough to push the first hike into September 2015,” Hatzius wrote.

Hatzius sees scenarios in which a rate hike could come as soon as Q1 2015 or as late as some time in 2016. It’s not until early to mid-2016 when Hatzius sees labour market slack actually disappearing.

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