Debate: How Much Slack?
This morning’s worthwhile internet debate to watch is the ongoing debate over how much slack there is in the U.S. economy:
- Tim Duy
- Joe Weisenthal:
- Matthew Boesler:
- Jared Bernstein:
- Evan Soltas: | MOAR Evan Soltas:
- Josh Bivens:
Me? I would say that “normal” monetary policy would call for the first rate increases when the JOLTS quit rate crosses 2% heading north. But I would also say that right now and for the foreseeable future “normal” monetary policy is not appropriate: the inflation rate was clearly too low going into the financial crisis to give monetary policy enough room to maneuver–an inflation target of 3% or 4%/year is clearly much more appropriate than a symmetric inflation target of 2%/year, let alone the asymmetric inflation target of 2%/year that we have. And I would say that right now the benefits of a high-pressure economy before our current cyclical unemployment has completed its transformation into structural unemployment are unusually large.
So, yes, I would say that pretty much any sensible cost-benefit analysis would postpone the first rate increases on the current track until 2016 or 2017…
As a consequence, indications that slack is less than expected will tend to move forward the timing of the first rate hike and, perhaps the pace of subsequent tightening. Wage pressures are likely to be an early indicator that slack is diminishing. I see two flavors of uncertainty…. First is the question about the value of the unemployment rate as a signal…. [The argument that] the unemployment rate is underestimating the degree of slack… is becoming less persuasive by the day. Evidence seems to be mounting… that retirement and illness/disability are a dominant reason for labor force exits since the recession began. Consequently, the decline in the labor force participation will be a persistent phenomenon. The Fed, I think, has largely moved in this direction.
The next issue is the degree of underemployment…. The hawkish view is that this is not a cyclical problem but a structural one. The long-term unemployed, by this theory, simply lack the currently needed skills…. I see evidence of the structural explanation in a comparison in the reasons for part time employment…. Doves will point to the lackluster data of the Jobs Openings and Labor Turnover (JOLTS) report to support the claim of weak labor markets with plenty of slack….
Wage growth will ultimately settle the debate. Wage acceleration tends to occur as unemployment approaches 6%. If that wage acceleration does not occur, then the degree of labor market slack remains high….
So far the Federal Reserve is behaving just as they would in any other tightening cycle, with the only difference being that the first step is ending asset purchases rather than raising interest rates…. Simply put, the Fed began unwinding policy pretty much exactly where you would expect given the behavior of unemployment and wage growth. So it is reasonable to believe that if they continue unwinding policy in a historically consistent manner, then there will not be a substantial pause between the end of asset purchases and the beginning of rate hikes….
Could they delay rate hikes? I would like to see them do so because absent running the labor market at a red hot pace, I don’t see obvious way to shift the balance of power to labor…. That said, I would also add that the last two cycles leave me wary about the potential financial stability issues from such a policy. In the absence of a greater fiscal role, however, we are left with leaning on monetary policy and risking the financial fallout.
Joe Weisenthal: Morgan Stanley: Economy’s Growth Potential Is Now 2 percent: “A new report from [Vince Reinhart of] Morgan Stanley argues that potential growth for the economy is now just around 2%.
The report argues that drops in productivity and Labor Force Participation mean a new, slower growth track than what we’re used to. This has significance for monetary policy, as there may not be as much “slack” in the economy as the Fed believes. Sorry. We’re not going back to the old normal….
So what’s behind the new slow potential growth rate for the U.S. economy? Reinhart identifies two big trends. One is declining Labor Force Participation Rate, a trend which started well before the recent slump. And the other is declining productivity. Fewer laborers and less productivity make it hard to keep up the same growth pace…. Again, the big ramifications here are probably for the Fed, which may get unwanted levels of inflation faster than they want or expect…
Matthew Boesler: Rate Hikes Back On Agenda Post Jobs Data: “Over the past several months, there has been a growing sentiment… that despite unprecedented weakness in certain areas of the labor market — long-term unemployment, for example — overall labor market slack is disappearing…
and the Federal Reserve is probably getting closer to considering hiking short-term interest rates than Fed officials want observers to believe. “You can argue that maybe the Fed has convinced investors of their commitment to low policy rates and a slow pace of policy rate increase in 2015 and beyond, but we find a lot of skepticism among investors that there is as much slack out there as the Fed has indicated,” said Steven Englander, global head of G10 FX strategy at Citi, before this morning’s release…. Money-market yields implied by 3-month eurodollar futures are up sharply, as are long-term interest rates — like the yield on the 10-year U.S. Treasury note, which is currently trading at 2.81%, seven basis points above Thursday’s closing levels….
Perhaps most significant were the data on wages contained in the jobs report. Average hourly earnings of private-sector nonsupervisory employees rose 2.5% from a year earlier in February — a fresh cycle high. “Given the uncertainty there is about how much slack is left in the U.S. labour market, this should be ringing alarm bells all over the place,” says Kit Juckes, a global strategist at Société Générale…
The “slackers” think we’re still facing sizable output gaps in GDP and jobs. The “quitters” think the job market is tightening up (based in part on recent movements in quit rates—more on that in a moment), and that wage and price inflation will follow….
Let me explain why you should quit the quitters and kick back with us slackers…. Quit rates…. The theory is that when workers who are unhappy with their job become more confident about finding a better one, they quit. And, in fact, as you see below, quits are a cyclical indicator…. They’re maybe about halfway back to their pre-recession peak, and as far as we can tell, that peak was below the previous one at the end of the 2000s cycle, a period where labor markets were a lot tighter than they’ve been anytime since…. What else have the quitters got? Evan also points to the fact that all the cool kids these days are breaking the unemployment rate up into the short-term rate and the long-term rate…. But here again, look at the latter 1990s—or even the latter 2000s. Both rates were below the averages. I don’t think an objective person would look at the end of the lines in the figure and conclude: “our work is done here, folks.” Especially when you consider the real bottom-line indicators of slack. You know, like:
the extent to which GDP is below its potential, which right now is about 4% of GDP, or around $700 billion (CBO);
the extent to which the unemployment rate is above the full employment rate. And here, I disagree with Evan, who suggests 6.7% is “close to most estimates of unemployment’s natural level.” His links show estimates of 5.5%, and a) the current jobless rate is biased down by labor force exits—I’d add a percentage point to it, and b) Dean Baker and I think 5.5% is too high for the natural rate.
the absence of wage or price inflation. No time to post figures on this, but they’re not hard to find. Price growth is especially quiescent and wage growth is flat or rising slowly (while inflation is decelerating).
End of the day, like a chronic dieter pushing away needed protein even when he’s clearly underweight, the quitters appear to be desperate to preempt any inflationary pressures. To them, the fact that inflationary expectations are low and “well-anchored” is a vital attribute for an economy that musn’t be trifled with…. To quit the field is to risk surrendering to permanent slack and depressed potential growth rates. I’d thus urge the quitters to take a closer look at the indicators above and join us slackers.
The first is that we’re “nowhere close” to full employment or meaningful capacity constraints…. The second is that, even if we are close, it’s worth chancing it with inflation because the benefits of a robust recovery greatly exceed its risks of taking it a bit too far…. Bivens… is the thoroughest update I’ve seen on the dovish case. What it boils down to is that the output gap looks big and employment is still depressed, and there’s no evidence of price inflation or fiscal crowding-out.
Where do Bivens and I diverge?… What I’d love to hear him answer: The U.S. is seeing 8 million too many quits a year for there to have been no reduction in slack in labor markets. That’s 6 percent of total employment. In fact, quits suggest the unemployment rate is accurately measuring labor-market slack. Avent’s and Garcia’s arguments are more interesting, and we agree much more than we disagree. Both are willing to accept that the output gap isn’t quite as large as Bivens suggests. Yet Avent and Garcia both say it’s worth pressing onward…. There’s no doubt that the costs and benefits of an “overshoot” of full employment are asymmetric. Stay too loose for too long, and you get a temporary bit of inflation. Exit too early, and you leave the work of fixing the recession unfinished forever. Who wouldn’t take the first one? The problem with this cost-benefit logic is that the consensus policy track already agrees with it, as do I, to the extent to which the logic works. Futures markets anticipate the first rate hike in the fall of 2015. Rate are then set to rise about one percentage point per year. This locks in a solid amount of “overshoot” already…. Markets… expect the Fed to cross its own estimate of full employment with its policy rate at zero. That’s extraordinary….
Here’s what I don’t get: What more do Avent, Garcia, Bernstein, and Baker — and more generally, the doves who say they disagree with me — want? I owe Ryan L. Cooper a shout-out here, too. Their implication is that a yet larger overshoot is desirable. Much of their arguments are abstract, but the specifics make it almost unbelievable: Should the first rate hike really come when unemployment has a four in the first digit? I’m all with them until that point. I think the expected path for monetary policy is already dovish, and wisely so. It was an awful recession. But there really is such a thing as “too much.” This is already quite a lot…. The reason the Fed is tapering now and talking ever more frankly about rate hikes is ultimately because yes, it’s about time.
This is new and, in my view, compelling evidence that labor markets are pretty tight. Why? Think about the decision to quit. It’s a function of your confidence that you’ll find a better job quickly — which embodies some unobserved but holistic measure of labor-market tightness. The fact that the unemployment rate appears to be a robust predictor of the quit rate both before and after the 2007-2009 recession suggests that the unemployment rate, our imperfect observation of labor-market tightness, is a close proxy for the tightness people think is important when they decide to quit or not to quit.
That the unemployment rate is not such a good proxy for an unobservable measure of labor market tightness is exactly the empirical claim underlying current monetary policy and, quite frankly, much of what I’ve spent the last two years writing about….
If the long-term unemployed are disconnected from the labor market, they really can’t matter much in a macroeconomic sense — that is, their unemployment no longer has the power to restrain wage growth or discourage the employed from quitting and switching jobs. It’s worth pointing the reader here to ideas like the insider-outsider theory of unemployment and labor-market segmentation. That’s why you can’t look at underemployment directly to conclude that the unemployment rate is misleading — because it assumes that underemployment is macroeconomically relevant, which is what you’re trying to prove….
Job-switchers don’t think the long-term unemployed are any competition at all. If they were — if the unemployment rate overstated the amount of labor-market tightness — then we should have seen the relationship break down. In particular, the curve should have shifted downwards and to the left. There should be fewer quits for any given rate of unemployment….
There is also a close intellectual connection in my chart to the Beveridge curve. It seems about as important. The Beveridge curve broke down during the recession because of long-term unemployment, as economist Rand Ghayad has shown. Mine could too. But if it did, that would be exactly the kind of evidence we’d need to say that labor markets are looser than they look.
Josh Bivens: Nowhere Close: The Long March from Here to Full Employment: “The prime-age employment-to-population (EPOP) ratio… is simply the ratio of adults between the ages of 25 and 54 who are employed….
As job opportunities became terribly scarce during and after the Great Recession, more and more potential workers began abandoning active search, simply because they could not find work. We have termed this group “missing workers” and assume that most would return to active search should job opportunities ever become plentiful again. Some have claimed that the decision to abandon searching for work was voluntary and unlikely to reverse even in a strengthening economy—and changing demographics of the labor force is frequently invoked as a reason why. The advantage of focusing on the EPOP is that such issues should matter much less. It is hard indeed to think why a much larger number of workers between 25 and 54 voluntarily decided right at the end of 2007 to stop working, and why it has bounced back so little since. In 2013 this prime-age EPOP was still 4 full percentage points below its 2007 value (and 5.6 percentage points below the 2000 value, which arguably is a better approximation of genuinely full employment); a little less than a third of the falloff in this measure since the Great Recession’s EPOP trough has been recouped….
We know precisely the source of the demand shortfall: the bursting of the early and mid-2000s bubble in home prices. The result, as shown in Figure 3, was a $7 trillion decline in nominal wealth compressed in a couple of years. Take a standard estimate of the effect of housing wealth on household consumption and the prediction is roughly a 3–4 percent of GDP decline in annual demand. Besides affecting consumption, the decline in home prices led to another 2 percent of GDP decline in residential investment (why build new homes when the price of existing ones are plummeting?). Take standard estimates of the accelerator effect of overall economic activity on business investment and one can easily get another decline of 1–2 percent of GDP. Finally, as economic activity fell, tax collections fell. For state and local governments constrained (mostly) to balance budgets each year, this led to significant spending cutbacks at the subfederal level. In short, the fall in housing wealth in Figure 3 can fully explain the size of the resulting demand shortfall….
The recovery has not improved with time…. If one reads economics reporting in major media outlets, one often gets the impression that economic activity and employment is always beginning to accelerate relative to earlier stages of the recovery, and yet this durable acceleration just has not yet shown up in the data…. At this point, the current recovery’s weakness can essentially be entirely explained by the [government] spending austerity. Take the gap between public spending in the current recovery compared with the recovery following the early 1980s recession…. If we simply spent the way we did following the last very sharp recession, we would have achieved a full recovery by now. Boosting public spending is therefore the clearest path to spurring an acceleration of growth in coming years….
Full employment is too important for complacency
And this relative disinterest in using the two levers of macroeconomic policy (fiscal support and exchange rate policy) that could actually work to spur demand enough to restore the economy to full recovery explains… the size and persistence of the output gap….
The size of the demand shock inflicted by the burst housing bubble simply broke many of the economy’s self-regulating mechanisms. The most obvious one is the Federal Reserve’s control over short-term policy interest rates. The Fed had moved these rates to zero by late 2008, yet the recession deepened and recovery has been slow in coming. And even as nominal short-term rates were buried at zero, real rates actually were often slightly rising over this period as inflation decelerated. What Figure 13 should remind us of is that full recovery should not be assumed to happen regardless of policy choices. Second, over the past generation advanced economies have indeed seen literally decades of potential income generation sacrificed due to large demand shortfalls that were never decisively remedied by macroeconomic policy….
The policy course we’ve taken—particularly the extreme austerity on the spending side of fiscal policy—it’s no real mystery why the U.S. economy remains so depressed even as it enters its seventh year since the Great Recession began. The immediate future does look brighter on this front: Austerity’s grip will be substantially loosened in 2014. But it seems like it would make more sense to use policy to affirmatively boost growth and spur rapid recovery than to just reduce policy’s drag and hope for the best. Full recovery, and full employment, are far too important for this kind of complacency.