Unemployment Is The Right Metric For Janet Yellen To Guide Monetary Policy

Includes: DIA, IWM, QQQ, SPY
by: Michael Blair

A lot of ink has been spilled recently about unemployment often suggesting the unemployment rate is understated because of declines in the so-called "participation rate". Some are suggesting that newly appointed Fed chief Janet Yellen should forget about using the unemployment rate as the metric for monetary policy. In my opinion, those people are wrong.

Source: Zero Hedge

The participation rate today is about 62% to 63% which is about where it was in 1978. During that 36 year period it increased from 62% to peak at about 67% and since 2000 has been in a steady decline.

Participation rate is the ratio of people employed or looking for work to the "working-age population" usually taken to mean those persons aged over 15 or under 65. The denominator is those employed or actively seeking work.

How do we know who is actively seeking work? The best we can do is take a survey and that is where the data get murky.

In my view, a better statistic is simply the ratio of those employed to the working age population. That is an economically relevant ratio since it omits desires and preference and just measures who is earning income among those considered working age.

Based on census data projected to 2015 the "working age" population of the United States is the difference between the 255,161,000 who are sixteen and over and the 47,695,000 people over age 65, or in round numbers 207 million.

Source: United States Census Bureau

The Labor Department uses a term "civilian non-institutional population" meaning those over 16 who are not in either the military or a prison or mental facility. In January 2014 that number was 246,915,000. It is used in the calculation of the participation rate which purportedly "measures" the estimated number of people of working age and either working or looking for work. I don't know who is served by leaving out the military. For my money, those in the military are "working".

The Bureau of Labour Statistics issues a monthly report setting out the data. It suggests an alarming 91,455,000 people are "not in the labour force" suggesting they could be if they desired.

Source: Bureau of Labor Statistics

That statistic prompts articles like the one I recently read on Zerohedge.com showing the alarming growth of "People not In Labor Force".

Source: Zero Hedge

I think a more objective look at the data might be useful. First, 53 million of those 91 million people are past retirement age. I doubt that a high percentage of them are actively "looking for work".

The fact is that 145 million people were employed in January 2014. That would be about 70 percent of the working-age population of 207 million which includes those in the military. There is a small error in comparing January 2014 employment data to 2015 population projections but I can assure readers it is a very small error and understates the ratio by a smidgen.

Let's look back a few years to 2007 just before the financial crisis. In January 2007, 137 million people were employed. The working age population that year was 200 million. That year the ratio of employed to working age would have been 69%, less than today.

The fact is the ratio of those with jobs to the working age population has been reasonably stable moving up or down a couple of percentage points in the economic cycle. The frenzy of dramatic reporting claiming there is a massive number of people who have abandoned all hope and left the labor force, often termed the "hidden unemployed" simply does not hold water.

No one reports the ratio of employed to working age population since for whatever reason the nation's statisticians have their own views on what ratio is the important one. As a result, investors have trouble knowing whether things are improving or not because the data are all over the map and in many cases suffer from soft measurements. I don't know how many times I have heard the issue debated on programs like the Kudlow Report or Bloomberg TV, but it seems like a weekly debate. What I get from the discussion is that investors treat the unemployment rate with caution and do not put a lot of faith in the number.

One ratio that is reported is the ratio of employment to total population. It was stuck in the 55% to 60% for 30 years following World War II and then rose quite dramatically into the mid 60% range before falling back to about 58% in 2010.

No one should be surprised at that rise, at least no one my age. The post war baby boom entered the workplace beginning in early 1960's and their numbers grew through the next few decades until they started to retire in the early 2000's. I was among them.

As the bulge from the baby boom went from first job to retirement, the ratio of employed to population settled back to the 55% to 60% range that was its pattern from 1945 through 1975.

Where is it today? It is right where you might expect at about 58% where it has been since 2010.

The big drop in the 2008-2009 financial crisis was as much a demographic trend as the result of the financial crisis and in my opinion the decline was going to take place anyway. Perhaps one value of the financial crisis is that it brought the fiscal issues looming in the demographic trends into sharper focus even if it attributed them to the crisis itself.

In my opinion, unemployment as reported by the Bureau of Labor Statistics is properly measured at about 6.6% and the recovery is following the pattern one might expect in an era where a large population of baby boomers entered retirement without being replaced in the working population by immigration or organic population growth.

Investors should realize that the size of the economy is highly correlated to the size of the working age population. It is growing very slowly and as set out in the table above by 2030 will have reached only 214 million, adding only 7 million to the 2015 figure in 15 years. At the same time, the population of persons the working-age population must support will grow from 114 million in 2015 to 144 million in 2030.

With 30 million more mouths to feed and only 7 million more working-age citizens, it will take a dramatic rise in the "participation rate" to avoid substantial increases in income taxes or drastic cuts in entitlements regardless of what party is in power. Such an increase will require major changes in our society in terms of how long we work, how we care for our children, and how we deal with longer life expectancy. Those changes will not come easily and will more likely be forced on to us rather than result from strong government leadership or democratic choice.

If Janet Yellen moves away from the unemployment rate as the criterion for monetary policy (tempered of course by inflation rates) she will run the risk of adding stimulus to an economy that cannot be stimulated further since it will have approached a level of employment to population that, when seen in the light of the real reasons behind the apparently "low" participation rate, is in fact what most would consider "full employment".

For investors, the cycle of dramatic stimulus is coming to an end and it should end. Interest rates will trend higher. As they do and if we are lucky, inflation will rise to a 2 to 3% level. Earnings growth will be sluggish and earnings multiples may decline. Long bonds are the most dangerous investment available in my opinion, and the possibility of lower stock prices is more likely than not as the market begins to factor somewhat higher inflation combined with lower growth in earnings.

A price earnings ratio of 13 to 15 for the market as a whole makes sense. Today it is at 17.1 using the S&P 500 as a proxy. That suggests a decline in stock prices of from 12% to 24% is in the cards.

There is a good case that the market is overbought as set out in an article by Mark Hulburt on January 17, 2014 on MarketWatch.com. Certainly, the Shiller price earnings multiple suggests that is the case. Prudent investors will have a reasonable cash position and hedge gains with options.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.