Janet Yellen is delivering her first Congressional testimony as chairman of the Federal Reserve this morning.
The biggest debate in monetary policy right now is the amount of slack in the U.S. labour market and the implications for the Fed’s accommodative stance.
Those who believe there is significant slack despite recent rapid declines in the unemployment rate point to labour force participation, which has been falling in tandem. Their theory is that discouraged workers who have left the labour force will re-enter when job prospects improve, driving the unemployment rate up again.
In other words, they view the drop in labour force participation as largely cyclical and not structural.
During her testimony, Yellen attributed the decline in labour force participation to both structural and cyclical factors. She cautioned that despite the drop in the unemployment rate, other measures — such as long-term unemployment and part-time workers who want full-time jobs — point to significant slack.
UBS economists Drew Matus and Kevin Cummins call that an “odd view of labour market slack” in a note this morning, writing:
As expected, she downplayed the progress of the unemployment rate and the importance of the unemployment rate itself arguing that the long-term unemployed and the number of workers who are part time but who want full time are also important to gauging the amount of slack in labour markets.
We do not view the long-term unemployed as necessarily “ready for work” and therefore believe that their ability to restrain wage pressures is limited. In other words, the unusually high number of long-term unemployed suggests that the natural rate of unemployment has increased. Indeed, when we have tested various unemployment rates’ ability to predict inflation we found that the standard unemployment rate outperforms all other broader measures reported by the Bureau of Labour Statistics. Although we disagree with Yellen regarding the long-term unemployed, our research does suggest that, perhaps unsurprisingly, the number of part-timers does have an impact on restraining inflation.
Interestingly, the Fed staff have finally come around to our way of thinking on the reasons for the decline in the participation rate — that it is largely driven by retirement of baby boomers. This also suggests that the Fed is moving toward a lower threshold level for payroll growth — the payrolls growth required to pull the unemployment rate lower. (We estimate that payroll growth of 100,000 per month or a bit lower is sufficient to hold the unemployment rate steady.)
In short, Matus and Cummins believe even the factors Yellen cites as evidence of cyclical slack in the labour market are themselves largely structural.
That is not to say that high long-term unemployment and part-time employment are not serious issues that need to be addressed. However, monetary policy may no longer be the best instrument with which to address them.
The implication is that the Fed may be focusing too much on alternative measures, which could cloud the path of monetary policy going forward, delaying the Fed’s exit from an era of extraordinary stimulus for the wrong reasons.