Click Here to Read the PDF  Yellen’s unusual priority for a central banker by Michael Collins, Investment Commentator at Fidelity

July 2014

Alan Greenspan in 2006 retired a hero after 19 years as chairman of the Federal Reserve. Within two years, the global financial crisis trashed his reputation as a prudent central banker. In February this year, Ben Bernanke stepped down as Fed chairman with endorsements – that are holding up so far – for how his radical remedies from 2007 prevented a greater disaster than the “Great Recession”. Janet Yellen’s reputation as Fed chair will largely depend on how she oversees the escape from the sweeping solutions Bernanke’s invoked.

The crux of Bernanke’s monetary radicalism was to cut the US cash rate to an historical low close to zero, protect the financial system via emergency loans that are estimated to have topped US$1.2 trillion[2] (A$1.4 trillion) and then to embark on three rounds of central-bank asset buying that have expanded the Fed’s balance sheet five-fold to more than US$4 trillion. He helped his successor by outlining in May last year the planned end of the Fed’s asset buying and then implementing the first drop in monthly purchases – the amount was reduced from US$85 billion to US$75 billion in January this year. Yellen has continued “tapering” the Fed’s asset buying, which is now down to US$35 billion a month and is on track to cease during the third quarter.

The ending of quantitative easing, for all the scares last year when Bernanke announced its inevitable end, appears to be proceeding smoothly enough. Perhaps far harder, and Yellen’s challenge only, is how to raise interest rates to more normal levels as the economy heads towards full employment. Investors are concerned that an unusual priority that Yellen brings to the Fed chair will delay rate rises for longer than necessary and that this postponement carries risks for the US economy. The predisposition that might delay rate increases is Yellen’s unusual focus for a central banker on the long-term unemployed, a group that includes those who have stopped looking for work and the underemployed.

Other challenges Yellen could face may well be trickier than just raising the cash rate, to be sure. In particular, she may confront the dilemma of needing to puncture asset bubbles in a stagnating economy. If the US economy keeps shrinking – it contracted at an annual pace of 2.9% in the first quarter – then all the speculation about when Yellen might raise rates is moot. Or conversely, perhaps no matter what Yellen does, the raising of the cash rate in the US will cause global ructions, as it often does, especially as monetary policies in Europe and Japan are loosening. Ultimately, though, it’s likely that the cash rate’s rise from close to zero will be among Yellen’s greatest challenges and will make or shatter her reputation. After all, monetary policy at its heart is about setting interest rates at an appropriate rate for prevailing economic conditions.

Restless idle

The Fed, like the Reserve Bank of Australia, is essentially tasked with two conflicting goals; tame inflation and full employment. (Other central banks such as the European Central Bank are only charged with keeping inflation at a reasonable level.) The Fed interprets its goal of price stability as keeping inflation at around 2%. Thus, it will increase the cash or Fed funds rate when economic growth is fast enough to reduce employment to a level that fans inflation through wages growth. The Fed generally holds that the jobless rate can drop to around 5.5% without stirring inflation, a level known by economists as the non-accelerating inflation rate of unemployment.

The bellwether jobless rate in June just gone was 6.1%. Fed watchers have calculated that if the US economy keeps adding about 200,000 jobs a month then the non-accelerating inflation rate of unemployment will be reached sometime late in 2015, assuming no change to the participation rate, which records the percentage of the population employed or looking for work. Bang. That’s around when Yellen should, according to the Fed’s template, raise the cash rate from the 0% to 0.25% level it has sat at since December 2008.

Well, not quite, investors fret because of Yellen’s concern for the unusually high percentage of the unemployed who have been jobless for a long time, the part-timers who can’t find full-time work and those who have dropped out of the workforce in despair of finding a job. The US Labor Department defines the long-term unemployed as those who have been without work for at least 27 weeks. In June this year, about 32.6%, or 3.1 million, of the US’ 9.5 million jobless were long-term unemployed compared with just 25% during the recession of the early 1980s. Reluctant part-timers amounted to 7.5 million in June this year compared with 4.3 million in June 2007. The participation rate in October 2013 fell to its lowest since at least 1978 when it tumbled to 62.4%, a 3.6 percentage-point drop from June 2007, though it had edged back to 62.8% in June this year. 

Yellen’s concern for long-term idle workers was highlighted in March this year when she spent an hour on the phone with some unemployed people in Illinois and spoke of the troubles of these “real people behind the statistics” in a speech.[3] She has previously talked about the “substantial social cost” of employment failing to reach its potential, the self-perpetuating nature of long-term unemployment and how atrophied skills among the unemployed lead to their exclusion from the workforce.[4] 

The US Labor Department estimates a truer level of unemployment with its U-6 measure, which adds back those who have dropped out of the workforce in despair plus the marginally attached. The U-6 measure estimates that the real jobless rate in the US was 12.1% in June this year, almost double the most-watched barometer of employment, the U-3 measure.

U-watching

Yellen’s concern for the long-term, or U-6, jobless is to be applauded. The economic significance of her concerns is that she thinks the Fed can help these people by keeping rates low. That is the disputed aspect to her thinking that could carry risks for the US economy.

A debate is swirling in the US about whether the high level of long-term unemployment is structural or cyclical. Some commentators contend that only a minority of the long-term jobless will ever find gainful employment again for various reasons including that companies discriminate against the long-term jobless. A just-released influential paper by three Princeton economists found the long-term unemployed only have a 10% chance of finding a job in any month, often only return to transitory work and are twice as likely to quit the labour force than find steady full-time jobs. [5] If the problem of the long-term jobless is structural, then low interest rates won’t help these people and these folk have little sway over wage settings. If these people are right then wage pressures might build in the US economy sooner rather than later for the employable pool of workers is smaller than thought. In a nutshell, the US economy will reach its non-accelerating inflation rate of unemployment faster than many expect.

Yellen, however, thinks long-term unemployment is a cyclical problem; that “the decline in participation likely represents labour market slack,” as she said in April.[6] Yellen has made many other similar statements that predict that the long-term employed, including those who have stopped looking for work, will be re-employed again as the economy improves. If she is correct then the U-3 measure of unemployment won’t drop as fast as some assume to the 5.5% level that portends rate increases. The US  economy may only boast a jobless (U-3) rate of 5.5% by 2017, as the IMF predicts. [7] That would mean postponed rate cuts.

What worries investors is that inflation is likely to be consistently well above 2% before then. The latest reports show the consumer prices in the US rose 2.1% in the year to May, even as wages growth stayed modest. The Fed’s preferred barometer of inflation, the price index for personal consumption expenditure, rose less, at 1.8% in the 12 months to May this year, but that’s still up from 0.8% in the year to February this year.

If inflation on most measures goes beyond 2% then inflation hysteria will pressure Yellen to lift the US cash rate well before the US economy reaches its non-accelerating inflation rate of unemployment. The big question for investors is whether she takes steps against inflation in time or whether she delays a rate increase to help the long-term jobless regain work.

At the moment, many investors think the Yellen Fed is too focused on long-term unemployment and that Yellen is too convinced she can help them. They fret that the Fed will be slow to hike rates and inflation will speed far enough past 2% to trigger a forceful Fed response, no matter what the jobless rate is. The problem when central banks are tardy in responding to inflationary pressures is that they often need to boost rates in bigger steps over a shorter period than otherwise to compensate. When this happens, the damage to the economy, bonds and stocks is generally significant.

To think along these lines is to implicitly buy into the narrative that central-bank policy debates are between hawks and doves when it comes to inflation. The reality is the discussion is generally between mega-hawks and hawks. Yellen’s concern about the long-term unemployed does her credit but only shows that she is a hawk. It would be a surprise if she let concerns about the long-term jobless jeopardise public confidence in the Fed’s anti-inflation credentials, faith that was first built when revered Paul Volcker headed the Fed from 1979 to 1987. If Yellen were to let inflation slip beyond her control, she would end up with a worse reputation than Greenspan, even before she’s retired.

US unemployment statistics come from the Bureau of Labor Statistics, a part of the US Department of Labor. See “Labor force statistics from the current population survey” at http://www.bls.gov/cps/#data. Among the databases, click on “Top picks” for “Labor force statistics including the national unemployment rate (current population survey – CPS)”. Other financial information comes from Bloomberg unless stated otherwise. The jobs report for June 2014 was released on 3 July 2014.

Important information
This document has been prepared by Financial Wisdom Limited ABN 70 006 646 108, AFSL 231138, (Financial Wisdom) a wholly-owned, non-guaranteed subsidiary of Commonwealth Bank of Australia ABN 48 123 123 124. Financial Wisdom advisers are authorized representatives of Financial Wisdom. Information in this document is based on current regulatory requirements and laws, which may be subject to change. While care has been taken in the preparation of this document, no liability is accepted by Financial Wisdom, its related entities, agents and employees for any loss arising from reliance on this document. This document contains general advice. It does not take account of your individual objectives, financial situation or needs. You should consider talking to a financial adviser before making a financial decision.