Saturday, 28 September 2013

Slowing US labour force growth, wages and Transatlantic inflation trends

Two weeks of travelling in the US and Europe and finally, a Saturday morning in Highgate. Markets have had the 'notaper' from Ben Bernanke, the 'No QE' from Mark Carney and the 'No negotiation on Obamacare' which threatens to bring the US government to a halt. Hey ho. And in the foolish world of financial markets on we go to another monthly Labor Report, next Friday.

When it was still summertime, I threw out some observations on the Phillips Curve, which seems to work well in Japan, a bit in the US and very poorly in the UK. The US labour market remains hugely important for monetary policy, even if Mr Bernanke went to some pains to make us understand there are no automatic consequences of a falling unemployment rate. Markets will still be watching  the jobs data (very) closely. So, here's a quote from July's Chicago Fed letter

"For the unemployment rate to decline, the U.S. economy needs to generate above-trend 
job growth. We currently estimate trend employment growth to be around 80,000 jobs 
per month, and we expect it to decline over the remainder of the decade, due largely 
to changing labor force demographics and slower population growth" 

That's a much lower estimate of trend employment growth than I might have come up with in the pub on a Thursday night. The August payroll gain was a 'disappointing' 169k and in the last twelve months the range has been between 332k and 104k, in other words, consistently well above trend. Hence the falling unemployment rate. But, this solid employment growth hasn't prevented GDP from growing by a relatively measly 1.6% in real terms. The bottom line, if I take the fine analysis from the folks at the Chicago Fed to heart, is that even if job creation continues at what Americans consider to be a paltry rate (180k or so per month of late), the unemployment rate will go on falling steadily.

Now if you don;'t believe there is any such thing as a 'NAIRU', you won't care about that. But you should be worried if you are one of those people who do think there is an unemployment rate below which wage growth accelerates (small rant here for me to repeat that the empirical connection between unemployment and wage growth is much less awful than that between unemployment and inflation).

Which brings me to a completely different topic - the Beveridge Curve. The US Federal Reserve employs armies of really talented economists, not only at the Chicago Fed. So, here is a great paper from Rand Ghayad at the  Boston Fed (many thanks to Mike Green in New York for sending it to me). The Beveridge curve shows the relationship between job vacancies and the unemployment rate, which reflects the amount of friction in the labour market. There ought to be a low unemployment rate when there are lots of spare jobs going, obviously. Mr Ghayad is one of many to observe an outward shift in the Beveridge Curve, which suggests that it take more vacancies to get the US unemployment rate down than it used to. In my simple mind, that indicates more friction in the labour market. Mr Ghayad shows that this is mostly driven by those who have been out of work for longer periods of time and proposes that much of this is due to changes in how long people can receive unemployment benefits in the US. But a shift outwards in the Beveridge Curve tends to suggest that more of the unemployed are not looking for jobs as hard as they used to, or are unsuited to them. They could be people who have been out of work for a long time who no-one will hire, or they could be unemployed CDO structurers, who are ill-suited to most other tasks. We used to call such people 'outsiders' in an insider/outsider theory of the labour market which explains why the long-term unemployed don't put downward pressure on wage growth elsewhere, and why the only people who ever get to manage premiership football teams, are people who manage top-class football teams somewhere else in Europe.  Professor Dennis Snower who is now the head of the Kiel Institute, had the misfortune of having to teach me about this 30 years ago. In Phillips Curve parlance, a shift outwards in the Beveridge Curve, increases the NAIRU level and if that is what is going on in the US, there is a likelihood that we will see a pick-up in wage growth as the unemployment rate falls from here.

On weekdays, when I'm earning my living as a fixed income strategist, I may worry about faster wage growth. On Saturday mornings, I say bring it on! But it does raise questions about the relationship between inflation and wage growth and it raises the intriguing question of whether the labour share of GDP, pummelled ever lower in recent years, is finally going to turn higher, at the expense of the profit share. Nice for people, not so nice for shareholders...

UK Inflation....

US wage growth (at 2.2% per annum) isn't affecting inflation (the core PCE deflator is languishing at 1.2% per annum). That may partly be because inflation is driven more by demand than wages. So if wage growth goes up because the labour force and population are growing more slowly, that also reflects sluggish overall demand. This is a neat theory to fit the facts, but is also immediately focuses my mind back on the UK. Because here, we are seeing an acceleration in population and labour force growth, notably in the South East of the country. This helps anchor wage growth, but also helps push up inflation. It pushes up inflation in the same way as is seen more frequently in emerging market economies, where population growth is a really big driver. The sectors of the UK CPI which are growing faster than overall inflation at the moment are food, drink & tobacco, housing, utilities, health and education. Away from food and drink, the price of utilities, health, education, and other services are going up largely because a growing population requires investment to increase capacity (more trains, tubes, water pipes, power stations, nurses and bin collectors) which is passed on to consumers because a cash-strapped government won;'t make the investment for us.  There is good news in the latest CPI data, insofar as the price of coffee and tea, beer, shoes and cars are all falling while photographic equipment prices are falling fastest of all, but I can't help thinking that the fact UK inflation is higher than it is in the US, or Euro Area, has more to do with structural strains on services than anything else. Meanwhile, a growing population will continue to anchor wage growth (so we can all grumble) and push up the one price that doesn't get properly reflected in the CPI data - that of flats and houses.

Sunday, 8 September 2013

Summer's over, tapering's coming but money is still easy.

I went for a walk this morning - 2 hours before I saw anybody at all. Water levels are low but rising. Summer's over. Stay-vacation visitors to Devon enjoyed the best weather in years in August but the pub is quiet now and the moor is empty.

The chart shows the 3-month average US unemployment rate. I put a trendline through it for fun. The fall in the unemployment rate is progressing at a very steady rate and on the current trajectory, will get to 6.9% by next April, 6.4% by the end of 2014. If the Federal reserve wants to have completed its 'tapering' programme and stopped buying bonds by the time the unemployment rate gets below 7%, they're going to have get going.

A falling unemployment rate is almost always better than the alternative. But the current downward trend is not accompanied by strong GDP growth, or strong real disposable income growth, or inflation Hence the unhappiness in some circles at the idea the Federal Reserve may be thinking about easing back on the monetary throttle.

That brings me back to the trend line. Most Americans, having seen an unemployment rate of 4 1/2% without any major inflation threat in the last cycle, can't see why 7% is the magic number today. Others argue, reasonably, that the unemployment rate is distorted by part-time work, and by people leaving the labour force.

The Fed references unemployment and inflation in its forward guidance for interest rates for two reasons. Firstly, because of a long-held belief there is a relationship between falling inflation and higher consumer price inflation. The evidence is dodgy. And secondly because it believes there is a relationship between inflation and the amount of spare capacity in the economy, but that is too complicated to talk about directly, so the unemployment rate is used as a proxy for describing the output gap. I wish policy-makers would resist the temptation to treat the rest of us as idiots and just say - we will keep policy easy until we're scared growth is so strong it might push inflation up.

The framework to policy does nothing for credibility and helps fuel the debate about where policy should go. But ultimately, the message we are going to hear, over and over again, is that 'tapering is not tightening'. The steady decline in the unemployment rate is going to be one factor, along with the strength of the ISM surveys and the housing recovery, to justify slowing the pace of bond-buying slightly. This month or next month? To my mind that's a tactical decision and in a perverse way, I think the Fed may feel that buying fewer bonds after a period of upward adjustment in yields gives them a better chance that they can slow their buying without causing untoward volatility.  But if they then start to really emphasise the fact that rates are on hold for a lot longer, and point repeatedly to the benign inflation backdrop - the core PCE deflator at 1.4% for starters - we will all eventually realise that monetary policy remains exceptionally accommodative.

Super-easy policy has driven and will drive asset price inflation. The adjustment that came from the shock news that super-easy policy won't really be left in place in perpetuity should begin to come to an end when tapering starts. Some people tell me equity valuations are high, others than M&A makes corporate bonds less attractive. EM outflows continue and maybe that promises more weakness. There are reasons for every single 'risk' asset to remain under the cosh even when the spike in bond yields finishes. But I'm a simple enough fool to know that something is going to have a fantastic autumnal rally on the back of near-zero rates. It would be nice if it were farmland prices, I suppose....

Monday, 2 September 2013

Ro-Ro for Dummies

Hélène Rey's paper on how the global capital flow cycle is largely driven by Fed policy and risk aversion ... went down a storm at the Fed's Jackson Hole symposium. The paper is definitely worth a read. My one-line summary for market participants is that this is an analysis of 'risk-on/risk-off' for posh people. That is to say, it puts an econometric framework around something we all observe all the time. It serves a very useful purpose in the process though, by allowing policy-makers to grasp what it is that drives the Ro-Ro phenomenon. See this next post from Laura Tyson on the bumpy ride facing emerging markets.

There is now broad agreement that the volatility in emerging markets has been caused first by the Fed's QE policies, which squeezed money out of US-based investment and into higher-yielding assets, often emerging market ones, and secondly the merest hint that super-easy policy can't last for ever, which has triggered a shocking reverse of these flows.

For the sake of light entertainment, I have reproduced an old chart below, which shows US real GDP and real rates, how they mostly move together and we have seen a number of periods when a big gap has ben allowed to develop. When real rates are too low relative to the real economy, asset bubbles have had a tendency to follow.

That's all nice and familiar, but Professor Rey's paper prompted me to re-draw it putting global growth against US real rates. The pattern's the same and the size of the current gap tells its own story. The world cannot escape the effects of US monetary policy and since 2012, Fed rates have been dramatically out of line with global growth.

Most people agree that what the world 'needs' is a new global financial system to avoid the volatility caused by  risk-on/risk-off. You don't always get what you need. The Fed isn't going to start setting domestic monetary policy to suit the global economy when that doesn't suit the US economy. In practise, I think that the alternative, and what professor Rey suggests is likely, is that capital controls will increasingly be seen as a reasonable response to crisis.

And finally, a sensible observation from Gene Frieda as the emerging market 'crisis' shows signs of easing. Emerging markets need to use the time that is afforded by floating exchange rates and large currency reserve pools to get to grips with domestic credit creation. They imported cheap rates from the Fed, and for too long too many have allowed credit to expand dangerously. Then, as US rates move up or simply dream about moving up, the credit cycle is turned on its head. The EM boom has had a nasty shock as US yields rise. Things can quieten down if the US market does. But one day, the Fed will hike rates.