Slack and inflation

Zach Pandl, Portfolio Manager and Strategist | July 21, 2014

  • Today’s low unemployment rate indicates modest slack in labor market, which implies earlier Fed rate hikes and/or more inflation risk.
  • The decline in labor force participation in recent years now looks mostly structural.
  • Investors should remain cautious around U.S. interest rate risk despite a solid first half of 2014.

Excerpted from Zach Pandl’s newest whitepaper

Structural weakness in labor force participation means there is less slack in the labor market than commonly believed. Limited spare capacity in turn implies earlier rate hikes and more risk that inflation eventually overshoots the Federal Reserve’s target.

In recent decades that target was “minimum unemployment,” with the minimum defined as the rate consistent with stable inflation. Judging by this standard, the unemployment gap today is less than one percentage point, implying a small amount of remaining labor market slack and only modest downward pressure on inflation (Exhibit 1). However, the most recent recession and slow recovery have raised questions about whether this definition of full employment remains valid.

Exhibit 1: Unemployment rate suggests only small amount of labor market slack

Unemployment rate (%)

Exhibit 1: Unemployment rate suggests only small amount of labor market slack

Sources: Haver Analytics, BLS, Federal Reserve, Columbia Management

Conceptually, the Fed’s working definition of full employment will be related to the risk of overshooting the inflation target. By focusing on narrow measures of labor market slack, Fed officials will run less risk of overshooting on inflation (and some risk of undershooting). By aiming for broader measures of slack, above-target inflation becomes more likely. Exactly how much risk the Fed is taking depends on the underlying state of the economy: in particular, how much of the weakness in broader measures of labor utilization is cyclical vs. structural.

Since the economy bottomed in mid-2009, real gross domestic product (GDP) has increased at an annualized rate of just 2.1%. If GDP growth could have been known in advance, standard macroeconomic models would have predicted a flat or rising unemployment rate over the last five years. Instead, after peaking at 10% in October 2009, the unemployment rate has declined to just 6.1% today. The primary reason for the steady decline has been falling labor force participation — and available evidence is pessimistic about the prospects of a rebound. Contrary to conventional wisdom, the traditional unemployment rate appears to be giving a broadly accurate signal about spare capacity in the U.S. economy (Exhibit 2)

Exhibit 2: Unemployment decline consistent with other data

Exhibit 2: Unemployment decline consistent with other data

 

By focusing on broad measures of underutilization, policymakers are signaling optimism about the economy’s productive potential and/or a high tolerance for overshooting. We think the former is inconsistent with the data and the latter is inconsistent with the normal conservative tendencies of central banks. Perhaps they are simply hoping for the best.

We think Fed officials will ultimately change their minds on the degree of labor market slack in light of compelling evidence and then fall back to a focus on the unemployment rate. Indeed, we may have seen early signs of this already, with the committee’s funds rate forecasts beginning to react to the falling unemployment rate this year. Any hints of a faster recovery in wage or price inflation would likely accelerate this process. Although Chicago Fed President Evans and others have advocated a willingness to overshoot the inflation target, we wonder if their message will change when above-target inflation becomes a clear and present danger.

Regardless of how the Fed’s views evolve, this is not a terribly attractive environment for high-quality fixed income — overshooting is not a term bond investors generally like. Despite healthy returns to interest-sensitive assets in the first half of 2014, we remain cautious on the outlook for the balance of this year. Limited spare capacity means one of two outcomes is likely: (1) earlier-than-expected rate hikes or (2) higher-than-expected inflation. The distinction matters for the shape of the yield curve, but both outcomes are unfriendly for Treasury duration.

Separately, limited spare capacity means that inflation risks have become more balanced. We are not concerned about the size of the Fed’s balance sheet and its ability to tighten policy when the time comes. Rather, traditional cyclical upswings in wage and price inflation could begin well before the Fed is expected to normalize policy. Thus, at current valuations we believe inflation-protected government bonds are more attractive than their nominal counterparts.