Jackson Hole: Uncertainty Remains

Janet Yellen has given her widely anticipated opening speech at the Federal Reserve Bank of Kansas City’s Jackson Hole Conference. As expected, she devoted her remarks to the labor market, which is the subject of this year’s conference. Her discussion covered a wide range of issues and questions concerning current conditions in the labor market and how they might or might not be changing. To be sure, she emphasized that while current market conditions are clearly improving, in some cases they are changing more rapidly than the Committee anticipated, there is significant room for more improvement.

Yellen’s presentation set up the remaining panels of the conference by highlighting what we currently know and don’t know about labor market dynamics and how those answered and unanswered questions are impacting the FOMC’s assessment of current market conditions. She not only explained why the headline unemployment rate is not capturing what is truly happening in labor markets but also moved beyond that simple measure to consider a host of other issues. These included: labor market slack and difficulties in measuring it; the recent changes in the labor market participation rate; the problem of the chronically unemployed; the role of people who are employed part-time but want full-time jobs; labor market flows in terms of quits and hires; workforce demographics and the impact of an aging workforce; the disappearance of so-called middle-skill jobs; the impact of disability rates, retirements, and school enrollments; and finally, the effects of the recession on wages and productivity gains.

But she also moved beyond just that discussion of key labor market issues to devote attention to how they are shaping the formulation of monetary policy. Implicit in her discussion was the dual role that labor market conditions and the measurement of slack are playing from a policy perspective. Her attention focused mostly on the Fed’s dual employment/inflation mandate, and here she emphasized the goal of promoting full employment in a way that broadly improves labor market conditions, rather than just seeking to lower the unemployment rate.

At the same time, there is also a second implicit role that labor market slack is playing in the policy debate, and that involves its impact on inflation. Most contemporary macro models focus on measurements of labor market slack and deviations of real GDP from its potential as indicators of possible inflation pressures. Tight labor markets and wage inflation – combined with an economy growing above trend – signal that inflation is or soon will be a problem. In the framework of such models, there is no financial sector and no role for money in the dynamics of inflation. Inflation is viewed as being driven solely by real-side factors. So, in this view, slack in labor markets combined with an economy growing at or slightly below trend is evidence that inflation is not a near term problem nor is likely to become one, so accommodative policy is not an issue. What the press and markets took away from the presentation was Yellen’s observation that, despite the labor market improvements that have occurred, considerable slack in remains, and hence, rates will remain low until greater improvement is evident. To be sure, Yellen and other Federal Reserve officials took great pains to emphasize that policy will definitely depend upon incoming data, so any inference about when the FOMC will begin policy normalization cannot be made at this time.

Where does the Fed’s posture leave those people who are now arguing that a policy move is now likely as soon as the end of the first quarter of 2015? Their conclusion is based largely on two considerations: first, on their optimistic forecasts that real GDP growth will exceed 3% for the second half of this year, further lowering the unemployment rate and putting upward pressure on wages, and, second, on the observation that the minutes of the most recent FOMC meeting suggested that there is growing talk of policy normalization.

Is this view reasonable? We won’t comment here on GDP projections, but we will comment on the minutes and the inferences being drawn. A careful reading of the minutes suggests a number of observations and conclusions.

First, the FOMC is initiating a discussion of how policy will be normalized is simply good planning but tells us little about how far off such a policy move actually is. Second, it is clear that there is no consensus as to how policy should be normalized, when the FOMC should stop rolling over its securities, how the four relevant policy rates (discount rate, interest rate on reserves, federal funds rate, and reverse repo rate) should be set relative to each other, what role forward guidance will play or what the timing will be. Indeed, the FOMC has just formed yet another committee to consider its communications policy. Given this lack of consensus – and the minutes make it clear that there are widely divergent views on all these issues – it is not realistic to assume that views will coalesce on these critical issues in just the next few months so as to enable a shift in policy as soon as March.

Third, even if there were a consensus, great uncertainty remains as to how markets will react to any policy move or even to a hint that a policy move is imminent. A sharp market reaction – and it is not unreasonable to fear that rates could jump precipitously as holders of large portfolios of low-yielding bonds dump them abruptly to avoid capital losses – could destabilize markets and derail the recovery. This point was raised as a possibility by former Fed Vice Chair, Alan Blinder, in an interview he gave at Jackson Hole on Thursday.

Fourth, both the U.S. economy and economies in the rest of the world are facing various headwinds that could pose problems for growth. Housing still hasn’t recovered. External demands for exports could slow because of slow growth worldwide. Then there numerous and significant geo-political issues, any one of which could further contribute to increased market volatility and threaten the recovery.

Finally, one must also consider the fact that the bulk of the FOMC voting members– which comprises the seven governors and President Dudley – control the policy vote. Only one clearly more hawkish voice, represented by President Lacker, will even have a vote next year. Thus, it appears from all the FOMC participants’ public utterances, including Chair Yellen’s speech at Jackson Hole, that the probability is extremely high that the Fed will wait rather than act preemptively. Thus it is likely that, in terms of labor market issues, conditions for a rate move will not be in place until at least the end of the third quarter of next year.

BY Bob Eisenbeis