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May 7, 2013

Fed Watch: Consistency of the Underlying Trends

Tim Duy:
Consistency of the Underlying Trends, by Tim Duy: Calculated Risk comments on this morning's JOLTS report:
Not much changes month-to-month in this report - and the data is noisy month-to-month, but the general trend suggests a gradually improving labor market.
This observation extends far beyond just the JOLTS report to virtually the entire set of labor market data. While we often get caught up in the month-to-month gyrations of various employment reports, the underlying trend of those data have been remarkable consistent:
General, consistent improvement is evident across an array of indicators. The pace of that improvement, however, consistently falls short of what is necessary to rapidly alleviate excessively high levels of underemployment, counter demographic trends impacting labor force participation, or induce significantly higher wage growth. And you can find that generally steady pace of improvement in other indicators as well. For example:
In short, it looks as if monetary policymakers have put a bottom under the economy but are unable to accelerate the pace of recovery. Whether the lack of acceleration is attributable to shortfalls on the monetary side of policy (insufficient quantitative easing, unwillingness to allow inflation expectations to drift higher, etc) or lack of cooperation of fiscal authorities (there seems to be no reason to hasten the pace of deficit reduction) remains a matter of debate. I tend to believe that the economy needs additional monetary and fiscal support, in part because I tend to worry that we will not lift off the zero lower bound in this recovery, setting the stage for even larger policy challenges in the next recession. In any event, regardless of where you think policy should be, right now it looks to be accomplishing something of a minimum by setting a floor for activity.
What does this mean for monetary policy going forward?
First, I think we will need to keep a focus on the trend and not think policy will be swayed (in either direction) by every gyration of the data. The data is inherently noisy, and the Fed will be looking through that noise.
Second, the Fed recognizes the same underlying consistency in the data, and likely concludes that there is little they can do to accelerate that recovery without further substantive changes to policy (dramatically increase asset purchases or changing the inflation target). The costs of those policy shifts are perceived to outweigh the benefits (this is a revealed preference at this point). Hence we should not anticipate the Fed will scale up asset purchases, even though this option was on the table in the last FOMC statement. Scaling up would only happen in the event of a sharp deterioration of the forecast.
Third, they will not scale up asset purchases as long as they expect the impact of fiscal contraction to have largely passed by the end of this year.  If not for the fiscal contraction, the economy would already be accelerating at a more rapid pace, and we would probably be looking at the Fed tapering off asset purchases sooner than later.
Fourth, even if the forecast for 2014 devolves into a continuation of the slow and steady improvement of the past nearly four years (!) since the end of the recession, I doubt the Fed will accelerate the pace of asset purchases. The problem is the 6.5% unemployment threshold for considering the path of short-term interest rates. Slow and steady improvement will place that threshold in sight by the middle of next year, and the Fed will want to be done with asset purchases well before the economy hits that threshold. That helps explain why FOMC members seem to have coalesced around an expectation that they can wind down and end asset purchases by the end of this year. In short, they will be increasingly hesitant to increase asset purchases (and more anxious to begin tapering) as we move closer to the 6.5% unemployment target.
Bottom Line: Pay attention to the underlying trend, discount the month-to-month noise. The farther out we get from the recession, that noise becomes less important. That underlying trend seems to be generally consistent with the unemployment rate coming within sight of the 6.5% threshold by the middle of next year, which explains the interest in ceasing asset purchases by the end of this year. Despite talk of the ability to increase the pace of purchases, I have a hard time seeing the circumstances that would make such a dramatic shift in policy direction. Such a shift will require a substantial negative shock that stalls the pace of activity and brings the threat of deflation back to the front burner - think circumstances that threaten to take out the Fed's current floor under the economy.

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