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News & Analysis US

Not Quite as Anticipated

September 3, 2014, Wednesday, 05:44 GMT | 00:44 EST | 09:14 IST | 11:44 SGT
Contributed by Raymond James

In her Jackson Hole speech, Fed Chair Janet Yellen presented a balanced look into the issue of labor market slack and how monetary policy should respond over time. While there is plenty of slack currently, the bigger questions are how rapidly that slack will be taken up and how the Fed should position monetary policy in response. Yellen offered no clear answers.

In past months, Yellen emphasized that the Fed is looking at a broad range of labor market indicators, not simply the unemployment rate and nonfarm payrolls. However, in her Jackson Hole speech, she noted that “estimates of slack necessitate difficult judgments about the magnitudes of the cyclical and structural influences affecting labor market variables, including labor force participation, the extent of part-time employment for economic reasons, and labor market flows, such as the pace of hires and quits.” Recent research suggests that the behavior of these and other labor market indicators have changed since Great Recession.

Yellen noted a “convenient way to summarize” the various labor market indicators. The Fed’s Labor Market Conditions Index, derived from 19 labor market indicators, “supports the conclusion that the labor market has improved significantly over the past year, but also suggests that the decline in the unemployment rate somewhat overstates the improvement in overall labor market conditions.”

Yellen had apparently read beforehand the research papers presented at the KC-Fed’s monetary policy symposium, as she incorporated some of the key findings into her speech. Notably, the labor market is significantly less fluid, reducing employment opportunities, keeping unemployment higher, reducing productivity growth, and limiting wage growth.

Another possible explanation for the weak recovery in the labor market is the concept of polarization — growth in high-education, high-wage jobs, growth in low-education, low-wage jobs, and not much in between. One of the papers presented in Jackson Hole makes a compelling argument that this bifurcated labor market phenomenon is due less to technological change and more to globalization and the aftermath of the housing collapse. This need not be permanent, but adjustments are likely to be slow, costly, and disruptive (more on this next week).

A key issue in labor market debate is how much of the soft labor market recovery has been cyclical and how much has been structural, and whether cyclical weakness may be turning into structural weakness. Yellen noted that “despite challenges in assessing where the share of those employed part time for economic reasons may settle in the long run, the sharp run-up in involuntary part-time employment during the recession and its slow decline thereafter suggest that cyclical factors are significant.” Moreover, “the balance of evidence leads me to conclude that weak aggregate demand has contributed significantly to the depressed levels of quits and hires during the recession and in the recovery.”

“The pattern of subdued real wage gains suggests that nominal compensation could rise more quickly without exerting any meaningful upward pressure on inflation.” And, “since wage movements have historically been sensitive to tightness in the labor market, the recent behavior of both nominal and real wages point to weaker labor market conditions than would be indicated by the current unemployment rate.” However, Yellen went on to suggest three reasons to be more cautious. One is that firms may have had difficulty in cutting wages during the downturn. This “pent-up wage deflation” may be leading to more modest increases in nominal wages currently. Second, weak wage growth may reflect secular trends, such as changing patterns of production and international trade (and possible measurement issues). The third possibility is that dislocations from the Great Recession may be leading to a more permanent lower trend in wage growth, as those dropping out of the labor force may face a difficult time coming back.

Turning to monetary policy, Yellen noted that given the “substantial” degree of slack in recent years, “the need for extraordinary accommodation is unambiguous.” However, Fed policymakers are “naturally shifting to questions about the degree of remaining slack, how quickly that slack is likely to be taken up, and thereby to the question of under what conditions we should begin dialing back our extraordinary accommodation.” As Yellen noted there are dangers in raising rates too soon as well as too late. “There is no simple recipe for appropriate policy in this context.”