February job market data were stronger than expected. However, the Employment Report was not as strong as it appeared. Mild weather likely helped the payroll figure, while the unemployment rate fell mostly because people dropped out of the labor force. This isn’t the “substantial improvement” the Fed wants to see (as a threshold for ending QE3).
Let’s review the Fed’s monetary policy framework. In its forward guidance, the Fed plans to keep the overnight lending rate (the federal funds target rate) exceptionally low (0% to 0.25%) for at least as long as 1) the unemployment rate is above 6.5%; 2) inflation one to two years out is projected to be below 2.5%; and 3) inflation expectations remain well anchored. These are thresholds, not targets, guideposts, not goals. For example, the Fed could keep the federal funds target rate low even if unemployment falls below 6.5%, if inflation was projected to be well below the 2% target rate. The Fed expects to continue its Large-Scale Asset Purchase program until it sees “substantial improvement” in labor market conditions. This qualitative threshold is vague. In making its assessment, the Fed will weigh a number of economic indicators, including the unemployment rate, measures of job loss and hiring, and the quit rate.
The Fed has had a public debate in recent weeks regarding the costs and benefits of its policies. That debate appears to have been settled for the foreseeable future, based on comments for Chairman Bernanke and other senior Fed officials. The Fed will monitor for signs of financial instability, but sees the benefits of low interest rates as significantly outweighing the risks. These benefits are centered on the labor market.
There’s a concept in economics, as well as other fields, called hysteresis, which means that the future is dependent on the past. Unemployment has clear costs for individuals, the loss of income, strains on the family. More troublesome is that those that have experienced long periods of unemployment are much less likely to be hired. Some of this may simply be the stigma of having been unemployed, but the long-term unemployed lose work skills over time, which makes it harder to find a job. The Bureau of Labor Statistics tracks long-term unemployment, but people have a tendency to give up looking for a job after their unemployment insurance benefits expire. Thus, the problem is worse than the official figures indicate (currently, those out of work for more than 27 weeks account for more than 40% of the unemployed, vs. well below 20% in normal times). In addition, many people graduating high school and college are not getting the job skills they would normally acquire.
Another form of hysteresis has to do with GDP. The longer the economy remains far below its potential, the greater chance that potential output itself will be lower. A subdued pace of business investment implies lower potential output in the future. A short recession need not be too disruptive, but a long downturn can lead to slower economic growth in the future. Indeed, the Congressional Budget Office has lowered its projections of potential GDP growth significantly in recent years.
The February payroll figure appears to have been helped by mild weather. In the Household Survey, the Bureau of Labor Statistics calculates the number of people who couldn’t get to work due to bad weather. The February figure was significantly lower than the average of the ten previous Februarys. This figure is not directly comparable to the payroll data (which comes from the Establishment Survey). However, it suggests that mild weather played a role in February’s payroll gain. Last year, a mild winter pulled forward seasonal job gains that would have normally occurred in the spring and early summer. We could see a similar pattern this year
Make no mistake. The job market is improving, but it’s far from the type of strength that the Fed wants to see.
© Raymond James
