Labor market takes center stage

Zach Pandl, Portfolio Manager and Strategist | October 15, 2013

  • Labor market issues have long taken a central role in Janet Yellen’s career.
  • Remarks indicate Yellen views current labor market challenges as potentially very costly for the economy, and she sees a role for monetary policy in promoting recovery.
  • Yellen’s nomination likely raises the bar for Fed tightening, as long as inflation remains low.

When it comes to the current priorities for monetary policy, investors already know where Janet Yellen stands. In her own words: “With employment so far from its maximum level and with inflation running below the Committee’s 2% objective, I believe it’s appropriate for progress in the labor market to take center stage in the conduct of monetary policy” (Yellen, March 2013).

Labor market issues have long taken a central role in Yellen’s career. As an academic economist her most well-known research focused on an idea called the “efficiency wage theory”, which argues that firms set wages in an effort to promote worker morale and thereby improve productivity. For the economy as a whole this theory helps explain involuntary unemployment, because efficiency considerations move wages away from the market equilibrium. Some of her other work focused on topics like labor market turnover and the psychological effects of job loss.

Yellen is also unique among policymakers in regularly describing labor market developments in personal terms. For instance, in her confirmation hearing for Fed governor in 1994, Yellen said that she hoped to keep in mind “the people behind the numbers”. Similarly, in discussing employment conditions earlier this year, she stressed: “These are not just statistics to me.”

Besides this difference in style, however, Yellen’s basic framework for relating the labor market to monetary policy has historically remained close to the “New Keynesian” mainstream. This is reflected in the types of models she relies on in her analysis as well as her qualitative descriptions of the Fed’s role and objectives. The following quote appeared in a 1995 interview with the Federal Reserve Bank of Minneapolis, shortly after Yellen joined the Board:

“I would agree that the Fed probably cannot achieve permanent gains in the level of employment by living with higher inflation. But the Federal Reserve can, I think, make a contribution on the employment side by mitigating economic fluctuations—by stabilizing real activity. I thus translate the ‘maximum employment’ proviso of the Federal Reserve Act as a mandate for the Fed to lean against the wind, stimulating the economy when the economy is in recession or unemployment is clearly in excess of the NAIRU (the non-accelerating inflation rate of unemployment—the minimum rate of unemployment consistent with stable inflation), and restraining the economy through tighter policy when economic activity is pushing against the limits of capacity with inflationary implications.”

This view would be shared by the great majority of mainstream macroeconomists today, both in academia and the policy world. Thus, there’s nothing special about Yellen’s basic model or framework that would dictate a shift in course from the Bernanke-led Fed.

At the present moment, however, even mainstream economists are divided over certain labor market questions, and here Yellen falls more obviously to one side. We would highlight three distinguishing features of her current views. First, she consistently argues that elevated unemployment reflects a cyclical shortfall in demand, rather than structural changes in the labor market. Second, she worries that long spells of unemployment could make job seekers less employable in the future, which would raise the natural rate of unemployment—an effect known as “hysteresis”. Third, Yellen worries about cyclical weakness in the labor force participation rate (LFPR), though we are not sure to what degree. In a nutshell, Yellen views current labor market challenges as potentially very costly for the economy, and she sees a role for monetary policy in promoting recovery.

Yellen’s views on the LFPR could prove important to the evolution of policy over the next year. In a speech in March, she argued that high long-term unemployment could lead to “a persistently lower rate of labor force participation” if jobless workers decide to drop out of the labor force. The idea that high long-term unemployment causes the LFPR to fall is a relatively new idea (at least to our knowledge). It was articulated in a widely-circulated paper written earlier this year by economists Christopher Erceg and Andrew Levin, who also serves as Yellen’s de facto Chief of Staff at the Board. The Erceg/Levin hypothesis could have major implications for monetary policy, including the appropriate design of forward guidance. Changes to the Evans Rule could be on the way if Yellen embraces this view.

Yellen has been refreshingly transparent about the indicators she will be watching to determine when there has been a “substantial improvement” in the labor market outlook—the condition necessary for ending quantitative easing (QE). These are:

  1. The unemployment rate
  2. Payroll employment growth
  3. Gross layoffs and gross hiring
  4. The quit rate
  5. Overall economic growth

Generally these indicators have been moving in the right direction, although the pace of expansion in both jobs and overall GDP has not yet accelerated. We unfortunately do not know precisely what threshold would qualify as satisfactory for each indicator. At the time of the September FOMC meeting, we were presumably still too far from “substantial improvement” for the set of indicators as a whole to begin slowing the pace of QE.

More broadly, although Yellen’s basic framework is close to the mainstream, she comes down on the cautious side of current labor market debates. Plus, her policy bias generally tends toward the side of greater activism (see our earlier note on optimal control, for example). As a result, Yellen’s nomination likely raises the bar for Fed tightening, as long as inflation remains low.

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