J.P. Morgan Funds: Lack Of Slack -- Why Aggregate Unemployment May Be Masking Wage And Inflation Pressures

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 |  Includes: DIA, QQQ, SPY
by: J.P. Morgan Funds

Anthony M. Wile
Global Research Analyst
Global Market Strategy Team
J.P. Morgan Funds

Overview:

  • A historically large number of long-term unemployed, representing 36% of joblessness, have kept the unemployment rate elevated which could be distorting the traditional tradeoff between inflation and unemployment dynamics.
  • The short-term unemployment rate continues to tighten, which has historically and meaningfully influenced wage growth and consequently inflation. Given this dynamic, higher-than-expected inflation in late 2014 could accelerate market expectations of when the Federal Reserve will begin to raise the federal funds rate.

Chart A: The Unemployment Rate by Duration

Seasonally adjusted, quarterly

Click to enlarge

Sources: BLS, J.P. Morgan Asset Management. The unemployment rate for short-term unemployed is calculated as individuals unemployed less than 26 weeks as a percent of the labor force, while long-term unemployed are individuals unemployed for 27 weeks or more. Data as of 2/12/2014.

In our previous paper, A Problem with the Numbers: Unemployment and the Fed s timetable, we explained that the natural rate of unemployment-the rate of unemployment below which inflation tends to accelerate-could be higher than the Federal Reserve assumes given the current number of long-term unemployed. This could potentially put the Fed in a difficult position regarding monetary policy since stronger-than-expected inflation could undermine dovish forward guidance, and thereby increase market yields later this year. In this follow-up piece to our earlier paper, we examine the components of the total unemployment rate, assess the implications of different trends among short- and long-term unemployed, and discuss how those groups influence wage growth and inflation.

Implications of the long-term unemployed

To the Fed's dismay, the unemployment rate has remained stubbornly elevated in the four years since its 10% peak in 2009. However, those elevated levels stem from a unique aspect of the U.S. labor market following the last recession: the persistence of the long-term unemployed, or individuals unemployed for 27 weeks or more. As shown in Chart A, the long-term unemployment rate is still above its peak in any prior modern recession, widening the gap between the total unemployment rate (as measured by the BLS' official unemployment rate, U3) and the short-term unemployment rate (individuals unemployed for six months or less). Currently, assuming the long-term unemployment rate fell to its 50-year average of 1.1% (Chart A), this would imply a total unemployment rate of only 5.3%.

For the Fed, the long-term unemployed may also be distorting its gauge for the second part of its dual mandate: controlling inflation. As we have noted in our previous paper, workers who remain out of work for an extended period lose essential human capital as their skill sets decay, making it harder for them to get hired by employers. As a result, the long-term unemployed lose their ability to negotiate higher salaries, therefore placing little upward pressure on wages and, in turn, inflation. Empirical evidence supports this gloomy claim with long-term unemployed exerting very little statistical influence on wage growth (Chart B).

However, while the long-term unemployed, which represent 36% of the unemployed population, exert little pressure on wages and inflation in the short- to medium-term, there are long-term consequences. Erosion of nearly 40% of the unemployed population's skill set impairs the productive capacity and potential output of the economy. In addition, it is likely that some of the long-term unemployed were engaged in a fruitless job search only to remain eligible for extended unemployment benefits. If this is the case, the expiration of this program could cause many of them to leave the labor force altogether, further damaging potential output.

Chart B: Statistical Significance of Unemployed on Wages

T-statistic, 1980-2013, quarterly

Click to enlarge

Sources: BLS, J.P. Morgan Asset Management. Statistical significance as measured above by t-statistics is estimated from a multivariate regression on wage growth while taking into account short- and long-term unemployment, productivity growth and wage inertia. Data are as of 2/12/2014.

Falling short-term unemployment could lead to higher yields

Conversely, the short-term unemployment rate, which continues to tighten, has historically and meaningfully influenced wage growth and short-term inflation pressures (Charts A and B). As the labor supply shrinks, skilled workers' wage-bargaining power increases. Indeed, as of December 2013, the short-term unemployment rate rested at 2007 levels of approximately 4.2%, well below its long-term average of 5.0%. Further declines, or even stabilization, in the jobless rate for this group will most likely spur future increases in labor prices.

The year-over-year growth in average hourly earnings can be closely predicted using a regression model that includes as explanatory variables the short-term unemployed among other factors (Chart C). Assuming unemployment continues to fall at the same pace as 2013, holding other factors constant, the economy could experience stronger wage growth during mid- to late 2014. Higher wages, in turn, should ultimately apply upward pressure to consumer prices, particularly within the service sector. And, as certain transitory and one-time headwinds fade in 2014 (1), inflation looks poised to pick up, which has the potential to decouple yields from forward guidance as market expectations accelerate. While facing interim market volatility, the Fed may be left with two options. First, the Federal Reserve may address market volatility with stronger forward guidance, effectively deciding to tolerate higher inflation pressures while holding rate expectations constant well into 2015. Notably, this approach would be consistent with Janet Yellen's favored "optimal control techniques" for monetary policy. However, even in this scenario, the Fed risks losing control of long-term yields as the yield curve steepens reflecting increased inflation expectations. As a second option, the Fed may accelerate its forward guidance, which would most likely result in a shift up in the Treasury curve as interest rate expectations move forward for both short- and long-term yields. Nevertheless, regardless of the Fed's decision, either approach should result in increased rate volatility and higher-than-expected yields in the second half of 2014.

Chart C: Average Hourly Earnings Growth

Production and non-supervisory private workers, year-over-year, seasonally adjusted

Click to enlarge

Sources: BLS, BEA, J.P. Morgan Asset Management. Wage growth is estimated from a multivariate regression with variables including short-term unemployment, productivity growth and wage inertia. Regression is run on a rolling 10-year window with one quarter steps. Inputs are realized economic data in the forward quarter excluding 2014 forecasts which assume that productivity grows and the unemployment rate falls at the same pace as in 2013, while endogenously generating trailing wage data. Data are as of 2/12/2014.

(1)In 2013, specific one-time factors negatively affected the Federal Reserve's preferred inflation metric, personal consumption expenditures (PCE) deflator. These factors include one-time sequester cuts to Medicare and account for 25% of the PCE deflator.

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© JPMorgan Chase & Co., February 2014

Disclosure: I am long SPY.

Business relationship disclosure: This article was written by Anthony Wile, Research Analyst, J.P. Morgan Funds. This article was submitted on his behalf via the J.P. Morgan Funds' Seeking Alpha profile.