The Fed Is Not THAT Aggressive

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by: Evariste Lefeuvre

According to many analysts, there is a growing list of factors that may trigger an early return of inflation in the US. While the threat that a QE-induced inflation has definitely disappeared, there are some supply driven risks:

1. The decline in productivity growth was even stressed by Ben Bernanke. Yet, the recent productivity data are not a cause for concern as it grew by 1.7% in Q4 2013, bringing the unit labor cost (the difference between productivity gains and wage growth) back to 0.4% on a year-over-year basis. Even if there was a structural break in the early 1980s between inflation and unit labor cost, the relationship still holds and the recent reading should rule out any fears of a short run risk of wage-pushed inflation.

2. The gap between actual wage growth and expectation of higher income is wide, which means that wage expectations might increase as the recovery continues.

  1. There is a growing labor mismatch with reported pockets of strain for some employers in finding qualified workers (Beige Book). The gap between job opening and hires is growing in the manufacturing and construction sectors, but not anywhere else. Given that the elasticity of skilled-labor supply is rigid in the short run, this adds to the risk of wage-pushed inflation coming sooner rather than later in the US. Yet, it is worth underscoring that if the manufacturing sector could be the most threatening,
    1. it is the sector that registers the highest level of productivity, which means that it could increase wages without any significant pass-through into prices; and
    1. in construction there is still a huge amount of excess unemployed persons while the supply is under strain (lowest level of home for sales since 2005). This should be a temporary mismatch. The chart below shows what happened since the recovery: a sharp rise in the value added in the health service providing sector (against GDP but also against construction) that is also visible in the relative employment trend. It looks like employment failed to track the trend in activity recently. It should be a temporary mismatch since both sectors are in services and don't post structurally high productivity gains. The chart also kills the theory according to which the sectoral switch from construction to services created a huge labor mismatch: the health sector does not seem to have issues with hiring people (JOLTs data) and the construction sector is just waiting for a firmer recovery in construction to hire more (our scenario).

Economy-wise, the fall of the "hires" to "job openings" ratio came along with a fall in the participation rate, suggesting that the discouraged workers may have left the labor force due to their inability to match the skills required for the new jobs offered (chart below). This explanation could add up to the traditional demographic factors behind the decline of the participation rate and the sluggishness of the employment to population ratio.

Therefore, the decline in the participation ratio could be attributable to the cohorts that are the most likely to suffer from any skill mismatch: young people and individuals close to the retirement age. The charts below show an interesting pattern: the fall in the participation rate does not seem to be an age-related issue (the youth participation rate stopped falling after the crisis, while that of the 55+ group has stopped increasing) but rather a phenomenon that mostly impacted the middle-aged population.

The fall in the participation rate is due in part to demographic factors but this cannot really explain what happens for the middle-aged group. The downward trend could also be linked to the fact that this ratio is highly cyclical: whenever the unemployment rate falls (increase), the participation rate increases (declines) as there are more (less) job opportunities for people marginally attached to the labor force. Those should be young and 55+, but as we have seen, this has not been the case recently. It therefore seems that most of the fall is attributable to discouraged workers.

Discouraged workers are generally defined as people searching for work when the labor market is tight and give up searching during recessions. We should therefore speak of added/discouraged workers to explain a phenomenon that has been a controversial subject for a while. Working on the Great Depression, Woytinsky (1942) wrote that the depression created a large population of "added" workers, persons that entered the labor force when the head of the household became unemployed. For Clarence Long (1958), discouraged workers started to enter the labor force only once the unemployment rate started to fall.

The chart below shows episodes of strong swings in the participation rate generally come along with significant movement in the variation of discouraged workers (we use here the widest definition of the BLS - Not in labor force want a job now). In the late 90ies, as the unemployment rate went close to its structural level, the participation rate increased and the number of discouraged workers fell. Recently, the fall in the participation rate came along with a significant growth in the discouraged workers.

Over the same period sharp rise of people receiving disability insurance (DI). Since disabled individuals have less incentive to come back to the labor market once things get better, it could suggest that part of the drop of the participation rate for this age group could be long lasting.

Yet, the significant increase of people not counted in the labor force but "who want a job now" (a wider category that includes discouraged workers) during the years following the crisis still suggests that a large chunk of the drop could be cyclical, as those people are ready to come back to the labor market: this category explains 20% of the rise of the "not in labor force" category between 2009-12.

In any case, the fact that a large portion of the decline in the participation rate is linked to the discouraged worker phenomenon should alleviate the fear of a labor-market-induced inflation in the near future, as there might be some "added workers" returning once the recovery is clearly perceived as sustainable.

Bottom line: the fear of a rapid return of wage-pushed inflation risk in the US is clearly overstated. It looks like most of the factors that have been deemed structural - labor mismatch, fall in the participation rate - are actually largely cyclical. Therefore, the risk for the US economy to operate at full capacity soon is very low, hence the low risk of the Fed being behind the curve.

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.