Greg Ip

Articles by The Economist’s U.S. Economics Editor

A less dovish Yellen, a more dovish Draghi

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Aug 23rd 2014, 4:14 by G.I. | JACKSON HOLE, WY.

The contradictory signals generated by American labour market data in the last year have provided grist for both hawks and doves at the Federal Reserve. For hawks, the rapid decline in the unemployment rate shows slack in the economy is disappearing so the Fed should tighten soon. For doves, the low rate of wage growth suggests there’s plenty of slack and tightening should wait.

Since becoming chair, Janet Yellen has usually been in the second camp, on balance interpreting the data as suggesting there wasn’t any urgency about raising rates. Her speech to the Kansas City Fed’s Economic Symposium on Friday in Jackson Hole, Wyoming struck a different tone. True, it covered both sides of the debate without coming down on either; Ian Shepherdson counted “1 coulds, 20 buts, 11 woulds, 7 mights, and a magnificent 56 ifs.” But she raised enough questions about the dovish case to suggest her own convictions are weakening. She was not telegraphing the case for raising rates soon. But it should be a wake-up call for investors who assume she would spin all the labour data that comes her way in a dovish direction.

The main dovish case is that the fall in unemployment overstates the reduction in slack. Because of the decline labour force participation, many people who don’t work are no longer classified as unemployed. Some of the drop in participation is structural, for example because of retirements, and some is cyclical, because discouraged workers have stopped looking for work. Ms Yellen said the cyclical factors have reversed this year as discouraged workers return to the job market. This means the unemployment rate is a better indicator of the true state of slack than a year ago. The fact that people working part time for economic reasons is a still-high 5% of all workers is also considered evidence of hidden slack in the labour market. But Ms Yellen said it could also reflect structural factors such as the shift from goods production towards services and the decline of middle-skilled jobs.

The evidence Ms Yellen has cited most often for why slack still prevails is the weakeness of nominal wage gains. But Friday, she cited a new paper by the San Francisco Fed that offered a different take. During the recession, the argument goes, the surplus of qualified workers would have enabled firms to cut nominal wages, but nominal wages are downwardly-rigid: for reasons of law, custom or collective agreement, firms rarely cut hourly pay. So they have compensated by not raising wages as conditions improve. This is called “pent-up wage deflation.” But at some point that pent-up deflation will finish, and then wages could rise quite rapidly. This, Ms Yellen said, could take the Fed by surprise, “necessitating an abrupt and potentially disruptive tightening of policy later on.”

Doves note that nominal wages have not kept pace with productivity so the benefits of productivity have gone to profit margins, and labour’s share of GDP has shrunk. This means wages could grow faster than productivity for a while without pushing up inflation, just by clawing back some of labour’s share. Here again, Ms Yellen said a less dovish interpretation was possible: the decline in the labour share may reflect pre-recession structural factors such as “changing patterns of production and international trade, as well as measurement issues.” This means slack could completely disappear without wages ever catching up with productivity.

None of these represents a case for raising rates now; rather, they are forecasts of how the data may evolve in way that justifies raising rates. The Fed does not know how the data will evolve, and thus how it will react. Interestingly, Ms Yellen did advance one argument in the other direction. Profound dislocations in the labour market, she said, have driven many people out of the labour market and raised long-term unemployment, and these people might not exercise much downward pressure on wages.  It will take a much stronger labour market to bring those people back in – but by that point real wages might be growing and inflation rising. If the Fed were to then respond with higher rates, it would “prevent labor markets from recovering fully and so would not be consistent with the dual mandate.”

It’s hard to imagine the Fed standing still and risking higher inflation out of some bet that an army of hidden surplus labour will flood back in. Yet strategic considerations suggest that is the wiser course. Inflation is still below the Fed’s 2% target; it is difficult to conceive of the economy developing such a head of steam in the next few years that inflation shoots significantly higher than 2%. If the Fed were to fear just that and tighten too soon, it could abort the recovery, send unemployment higher, strengthen disinflationary forces, and push interest rates back to zero.  That’s the situation Japan has been trying to escape for15 years. By contrast, if the Fed waited too long and higher inflation did materialize, the Fed can move rates as high as it needs to deal with that problem. It might involve a recession, but that’s better than another lost decade.

Which brings me to the European Central Bank. As we note in this week’s leader, the ECB now faces weak growth, inflation at 0.4% and falling dangerously close to zero, and sinking inflation expectations, signaling a loss of confidence in the ECB. This is dangerously similar to what Japan looked like in the 1990s. A long period of economic underperformance had allowed inflation to drift closer to zero. Then a series of shocks – the Asian financial crisis in 1997, a domestic financial crisis in 1998, tipped it into deflation, and the Bank of Japan had almost no tools with which to counter.

The ECB would be wise to pull out the stops now to get inflation back up. Yet after his last press conference, Mario Draghi, the ECB president, sounded strangely dismissive of these concerns. He noted that excluding food and energy inflation was 0.8%, and he argued the decline in inflation expectations was all in the short term; whereas “long-term expectations remain anchored at 2%.”

At his speech on Friday in Jackson Hole, his tone was much less sanguine. Inflation, he noted,  has been on a downward path from around 2.5% in the summer of 2012 to 0.4% most recently. Departing from his prepared text, he said, if “low inflation were to last a long period of time, risks to price stability would increase.” He said inflation expectations had experienced a “significant decline at the long horizon,” by 15 basis points (five-year inflation starting in five years’ time). “If we go to shorter and medium term horizons,” the declines “are even more significant. Real rates in the short and long term have gone up.” Mr Draghi did not mention the possibility of broad quantitative easing by purchasing government bonds, but he seemed to open the door wider to the possibility. “The government council will acknowledge these developments and within its mandate use all available tools to ensure price stability over the medium term.”

“The risks of doing too little outweigh the risks of doing too much,” he said. This, of course, is the same Bayesian rationale the Fed has often used to justify added stimulus. It would be ironic if, just as the ECB were learning the same thing, the Fed had set it aside.

The original post is linked here.


Written by gregip

August 23, 2014 at 9:00 am

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