Yellen?s Three Big Questions (and a Few Others)

Speaking to the Economic Club of New York, Fed Chair Janet Yellen presented an analysis of the monetary policy actions taken to address the Great Recession and offered guidance on what will drive policy decisions going forward. The centerpiece of her talk was about the three big questions that the Fed has to answer. However, there are a number of other debates going on in economics right now that have long-term consequences.

The Fed’s first big question is how much slack remains in the labor market. Yellen has spoken at length about the job market. Indeed, her dashboard is full of gauges suggesting that we are a long way from full employment. The unemployment rate has fallen, but the decline overstates the improvement in the job market. Part of the decline in labor force participation is demographics (the aging of the population), but most is due to discouraged workers who have given up on finding a job (hence, are not officially counted as “unemployed”) or other individuals who would take a good job if offered. The Business Employment Dynamics data (3Q13 data are due on April 29) suggest that labor turnover has been remarkably low in recent years. Job destruction is trending low, but fewer workers are quitting to pursue more attractive wage offers elsewhere.

The Fed’s second big question is whether inflation is returning to its 2% goal. Some observers are still screaming that, even though it hasn’t show up yet, hyperinflation is just around the corner. Hogwash! Inflation is a monetary phenomenon, but it shows up through pressures in resource markets. The soft global economy means limited upward pressure on commodity prices. U.S. imports (raw materials and finished goods) have exhibited modest price increases over the last year. With plenty of excess capacity, we aren’t going to see bottleneck or production pressures pushing prices of goods significantly higher. The labor market is the widest channel for inflation pressures, but we’re still seeing limited compensation gains.

The Fed expects inflation to trend back toward the 2% goal, but a prolonged period of low inflation creates some risks for the economy. All else equal, a continued low trend in inflation would push out the expected timing of a Fed rate increase.

The third big question is what could derail the economic expansion. Obviously, we don’t know. Yellen cited examples from recent years (the greater-than-expected fiscal tightening and spillover effects from Europe’s crisis). Yellen noted that the Fed responded to unexpected weakness in the U.S. economy with aggressive policy actions (QE2, Operation Twist, and QE3).

Yellen said that because the course of the economy is uncertain, the Fed needs to “watch carefully for signs that it is diverging from the baseline outlook and then respond in a systematic way.” That doesn’t mean responding to short-term wiggles, such as adverse weather. Rather, policymakers will respond to more substantial changes in the outlook.

Economists, mostly outside the Fed, are currently debating the longer-term prospects for the U.S. economy. One issue is the possibility of secular stagnation (a concern worldwide, not just for the U.S.). Barring an acceleration in labor productivity, a slowdown in labor input (as the population ages) implies a slower trend in GDP growth. Real GDP has averaged a 3% annual rate over the last several decades, but dipped below the trend line in the Great Recession and appears unlikely to return to that long-term trend in the foreseeable future. Continued subpar economic growth will reduce potential GDP growth.

Another concern is declining real wages for the bottom 90%. Adjusted for inflation, median weekly earnings for full-time and salary workers were the same in 1Q14 as they were in 1Q05. Low wage increases will make it harder for households to service mortgage debt and student debt (which has tripled over the last 10 years). A declining middle class (and deterioration in the lower part of the upper-income cohort) should be an important concern for all Americans, especially investors.

(c) Raymond James

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