The Federal Reserve's Dilemma

A recent but little covered speech given in May 2015 by Janet Yellen provides us with her personal viewpoint on when the Federal Reserve should "lift-off" and what economic problems still exist that has held the Federal Reserve back from its "date with interest rate destiny".  Here are some of the salient points, starting with her observations on the Fed's first mandate, full employment, followed by her observations on the Fed's second mandate, price stability:

1.) Employment: "In recent months, some economic data have suggested that the pace of improvement in the economy may have slowed, a topic I will address in a moment. And even with the significant gains of the past couple years, it is only now, six years after the recession ended, that the labor market is approaching its full strength.

I say "approaching," because in my judgment we are not there yet. The unemployment rate has come down close to levels that many economists believe is sustainable in the long run without generating inflation. But the unemployment rate today probably does not fully capture the extent of slack in the labor market. To be classified as unemployed, people must report that they are actively seeking work, and many people without jobs say they are not doing so--that is, they are classified as being out of the labor force. Most people out of the labor force are there voluntarily, including retirees, teenagers, young adults in school, and people staying home to care for children. But I also believe that a significant number are not seeking work because they still perceive a lack of good job opportunities.

In addition to those too discouraged to seek work, an unusually large number of people report that they are working part time because they cannot find full-time jobs, and I suspect that much of this also represents labor market slack that could be absorbed in a stronger economy. Finally, the generally disappointing pace of wage growth also suggests that the labor market has not fully healed. Higher wages raise costs for employers, of course, but they also boost the spending and confidence of customers and would signal a strengthening of the recovery that will ultimately be good for business. In the aggregate, the main measures of hourly compensation rose at a rate of only around 2 percent through most of the recovery." (my bold)

We can see that Ms. Yellen, like many Americans, does not believe that the headline U-3 unemployment statistic provides an accurate portrayal of the real health of the U.S. jobs market as shown on this graphic from Shadowstats which shows an alternate unemployment rate of 22.9 percent which includes long-term discouraged workers plus U-6 unemployment:

2.) Price Stability: "Less progress has been made toward the other goal, price stability. Consumer price inflation remains below the Fed's stated objective of 2 percent. The notion that inflation can be too low may sound odd, but over time low inflation means that wages as well as prices will rise by less, and very low inflation can impair the functioning of the economy--for example, by making it more difficult for households and firms to pay off their debts. Overall consumer price inflation has been especially low--close to zero--over the past year, as the big fall in oil prices since last summer lowered prices for gasoline, heating oil, and other energy products. But inflation excluding food and energy, which is often a better indicator of where overall inflation will be in the future, has also been low, below the Fed's 2 percent objective both now and for almost all of the economic recovery. Inflation has been held down by the continued economic weakness during the slow recovery and, more recently, by lower prices of imported goods as well as the fall in oil prices. With oil prices no longer declining, and with the public's expectations of future inflation apparently stable, my colleagues on the Federal Open Market Committee (FOMC) and I believe that consumer price inflation will move up to 2 percent as the economy strengthens further and as other temporary factors weighing on inflation recede."

Here is a graphic showing how the year-over-year consumer price index has fallen to its lowest level since the Great Recession and its second lowest level since the mid-1950s:

Ms. Yellen goes on to note that there are three economic headwinds that have slowed the recovery:


1.) Housing:  The housing market has moved up in many regions of the United States, however, certain parts of the nation have not seen house prices recover significantly, particularly in the Northeast U.S. as shown on this graphic:


On top of this, mortgages are difficult to obtain for potential homeowners that have less that pristine credit records.


2.) Growing government debt levels:  The long period of low interest rates has lulled governments at all levels into taking on additional debt with little regard for the future.  This has created a situation where increases in interest rates will cause hardship for governments and taxpayers.  As shown on this graphic, while overall state deficit levels have remained steady since the Great Recession, they are still at generational highs:

Here is a graphic from Mercatus showing the overall fiscal solvency of the fifty states:

The bottom five states include Illinois, New Jersey, Massachusetts, Connecticut and New York.  These five states have low amounts of cash on hand and large debt obligations.  As well, unfunded state pensions hit a high of $4.7 trillion in 2014 with the top ten states' unfunded liabilities shown on this table along with the state pension funding level:


3.) Global Economy:  Ms. Yellen notes that the global economy is causing a drag on the United States economy.  At the time of her speech, she focussed on the problems emanating from the Eurozone, however, since then, the problems with Greece have been overshadowed by the slowdown in China, a crisis that is still in its embyronic stage.

One of the little discussed but key issues facing the Federal Reserve is time.  Since the Second World War, the average economic expansion has lasted an average of 58 months as shown on this chart:

The current expansion is now into its 75th month, the fourth longest since 1945.  As this point in the economic cycle, time is definitely not the friend of the Federal Reserve.  

With the world's most influential central bankers completely out of monetary policy ammunition and the economy looking somewhat shaky, the Fed may already be past the sweet spot when it could have raised interest rates so that it would replenish its supply of "ammunition" for the next economic downturn.  While many pundits seemed surprised by the Federal Reserve's reluctance to "liftoff" in mid-September, in the past, Ms. Yellen provided us with many reasons showing why this will happen later rather than sooner and why it will happen in very, very small increments.