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.

What Is Janet Yellen's Top Priority?

With Janet Yellen at the helm of the Federal Reserve, the business writers in the mainstream media are most curious about whether or not she will change monetary policies or if it will be business as usual.  As I have done before, I will take a look back at a few comments that she made back in December 2006, just before the wheels fell off the American economy, to get a sense of her priorities.

Here is one key comment:

"I have to admit that this time around I found it pretty challenging to read the tea leaves on economic activity. The data are providing distinctly contradictory signals. For example, several key indicators of aggregate spending have come in below expectations, and the Greenbook now sees real GDP growth this quarter and the next averaging a mere 11⁄2 percent. At the same time, the labor market continues to be strong and shows no clear signs of weakening, as evidenced by the November employment report. The latest information on inflation has been fairly favorable; but even with some signs of easing, the underlying trend in core consumer price inflation remains above my comfort zone." (my bold)

You will notice that she notes that the labor market in the U.S. continues to be strong and shows no clear sign of weakening.  Just in case you've forgotten, here's what happened to the nation's unemployment rate after this meeting of the minds:

 I yield the floor to Ms. Yellen:

"Overall, the data on spending paint a clear picture of an economy growing well below trend, but it seems as though the BEA hasn’t delivered this message to the BLS. [Laughter] The very latest data show payroll employment growing steadily. The household data are even more alarming. The unemployment rate has declined 1⁄2 percentage point over the past year and now stands at 41⁄2 percent, 1⁄2 percentage point below our estimate of the NAIRU. My business contacts tell me the same thing. Labor markets are tight, and jobs are hard to fill, especially for skilled positions. But some other indicators suggest that labor markets may have softened a bit. In particular, the Conference Board index of job market perceptions, based on a survey of households, declined in both October and November. This index is historically very highly correlated with the unemployment rate, but now it’s sending a different signal, suggesting that labor markets are roughly in balance. Similarly, in November fewer firms reported openings that are hard to fill." (my bold)

Again, Ms. Yellen comments on the strength of the U.S. jobs market, noting that the unemployment rate had fallen to 4.5 percent, a rate that we can only dream about now.

Why does Ms. Yellen have such a fixation with the unemployment rate?  Here's the answer:

"On the one hand, recent labor market data point to a lower path for the unemployment rate than before, and all else being equal, this boosts our inflation forecast a bit. Offsetting this effect, on the other hand, is the huge downward revision in compensation per hour. When these data came out, I let out a big sigh of relief. The revised data are more consistent with the indications we were getting from the employment cost index and suggest that wage growth has remained contained. In contrast, my contacts report intensifying wage pressures, resulting in part from more-frequent employee quits and outside offers." (my bold) 

That's right.  Being a central banker, Ms. Yellen's priority is NOT employment, it is inflation.  She was concerned that a rise in employee compensation (i.e. wage growth) could put upward pressure on inflation.  When there was a downward revision in compensation per hour, she let out "a big sigh of relief".

Let's look at real (i.e. corrected for inflation) hourly employee compensation since 1947 with 2009 being assigned an index value of 100:

Notice how the rate flattens around the turn of the new millennium?  Let's zoom in on that time period:

In 2000, real hourly compensation was 96.1.  This rose to a peak of 99.8 in early 2007 but fell rapidly during the Great Recession to a low of 96.6.  Real employee compensation hit a 13 year peak of 100.6 in the second half of 2012 but has since fallen to 99.2 in the third quarter of 2013.

If we look at all of the data since the beginning of 2000, we note that real hourly compensation over the 13 year period has risen by a paltry 3.2 percent, a much lower level than was seen during the second half of the 1990s and the period between 1947 and 1970.  Basically, what we are seeing is a 13 year period where the real growth in employee compensation has completely stalled.

Just in case you wanted to see how employee hourly earnings have changed on an annual basis, here is another graph from FRED showing the percentage change in hourly earnings from the previous year going back to 1965:

As you can quickly see, since the early 1980s, annual raises (for lack of a better term) have rained from 1.4 percent to around 4 percent.  These very low nominal compensation growth rates have led to real wage stagnation.  Corporations will attribute this lack of wage growth to low inflation, however, at the same time as worker wages stagnated, CEO and named executive officer compensation has mushroomed.

From Ms. Yellen's comments in 2006, we can gain a sense of her top priority.  She has shown us that she is far more concerned about the prospect of inflationary pressures in the economy than she is about growth (or, in this case, non-growth) in employee wages.  I suspect that we will be getting more of the same now that she is Chairing the Federal Reserve.

Janet Yellen on Housing

Updated February 2014

Now that Ms. Yellen's has taken over at the helm of the Federal Reserve, I thought that it was timely to take a look back at some of her historical comments on the American economy and see just how prescient she was.  In the first posting of this three part series, I looked at her commentary on the American job market.  In this posting, we'll be looking at what Ms. Yellen had to say about the United States housing market back in December 2006, just as the wheels were coming off the "housing bus".

Here is the quote:

"The correction in the housing sector has continued, even sharpening somewhat compared with our expectations.  Still, there are some encouraging signs that the demand for housing may be stabilizing, probably assisted by recent declines in mortgage rates. After a precipitous fall, home sales appear to have leveled off.  In addition, equity valuations for homebuilders have continued to rise in the past couple of months, suggesting that the outlook for these businesses may be improving.  Finally, the gap between housing prices and fundamentals may not be as large as some calculations suggest because real long-term interest rates have fallen quite a bit recently, raising the fundamental value of housing. That said, the housing sector on balance is a source of downside risk, and the risk could be magnified if mortgage rates were to rise again as foreseen by the Greenbook." (my bold)


Let's look at all three highlighted portions of her comments.  Here's a chart showing what happened to housing prices after this meeting took place:


Within two years, house prices had dropped by a little over 25 percent.  So much for the "fundamental value of housing.".

Here's what happened to the demand for housing in the U.S. as measured by sales numbers for single family homes after this meeting took place:

Within two years, single family home sales had plunged from 1 million to just over 330,000, a drop of 67 percent.  So much for a "levelling off" of home sales.

Lastly, let's look at what happened to the share price of D.R. Horton Inc. (symbol DHI), one of the largest homebuilders in the U.S., known for building relatively low cost homes after this meeting took place:

In late January 2007, DHI hit a high of $30.86.  By mid-November 2008, DHI had fallen to $4.34, a drop of 86 percent.  Since then, the stock has risen rather steadily, but it never regained its January 2007 high.  As far as profitability went, it took D.R. Horton until November 2012 to see its profits return to 2006 levels.  So much for "equity valuations for homebuilders continuing to rise".

As we can see from Ms. Yellen's commentary on the housing market and the employment situation, it would appear that central banking is a crap shoot, the only difference being that the house (the Federal Reserve) rarely wins, despite their efforts.

Janet Yellen on Employment

With Janet Yellen slated to take over as Chair of the Federal Reserve at the end of January 2014, I thought that it would be interesting to look back at Ms. Yellen's commentary on the U.S. housing market and other aspects of the economy way back on December 12th, 2006 at a meeting of the FOMC.  This meeting just happened to be the last meeting that Alan "Bubbles" Greenspan was head of the Federal Reserve.  Ms. Yellen is currently the Vice Chair of the Board of Governors of the Federal Reserve, having previously served as President and CEO of the Federal Reserve Bank of San Francisco from 2004 to 2010 when she attended the December 2006 meeting of the Federal Open Market Committee.

I will be posting Ms. Yellen's thoughts in three parts; employment, housing and inflation/productivity.

Let's start with the employment picture.  Here's what Ms. Yellen had to say about employment in the U.S. in late 2006:


"The very latest data show payroll employment growing steadily. The household data are even more alarming. The unemployment rate has declined 1⁄2 percentage point over the past year and now stands at 4 1⁄2 percent, 1⁄2 percentage point below our estimate of the NAIRU. My business contacts tell me the same thing. Labor markets are tight, and jobs are hard to fill, especially for skilled positions. But some other indicators suggest that labor markets may have softened a bit. In particular, the Conference Board index of job market perceptions, based on a survey of households, declined in both October and November. This index is historically very highly correlated with the unemployment rate, but now it’s sending a different signal, suggesting that labor markets are roughly in balance. Similarly, in November fewer firms reported openings that are hard to fill." (my bold)


Here's what happened to the U-3 unemployment rate after this meeting took place:

Jobs may have been "hard to fill" in late 2006 but, every month thereafter until mid-2009, the unemployment rate climbed more-or-less continuously until it hit 10 percent.

Here's what happened to the employment-to-population ratio after this meeting took place:

Note that the employment-to-population ratio dropped immediately after the December 2006 FOMC meeting.  More people with fewer jobs can hardly be termed a "labour market that is roughly in balance".

Since construction of housing formed such a key part in America's booming new millennium economy, let's look at what happened to construction employment levels after this meeting took place:

Within 12 months, construction employment had dropped from 7.725 million at the beginning of 2007 to 7.456 million at the beginning of 2008, a loss of over a quarter of a million construction jobs.  The level of construction employment continued to drop to between 5.4 and 5.5 million, a total loss of between 2.2 and 2.3 million jobs, most of which have not been replaced to the end of the third quarter 2013.

Apparently, America's job market "may have softened a bit" by the end of 2007, less than one year after the December 2006 FOMC meeting.  Perhaps Ms. Yellen's observations about employment in America back in 2006 were the economic understatement of the year!  While job markets may have been "roughly in balance" at the end of 2006, things began to unravel very quickly and, within 12 months, the U-3 unemployment rate had risen to 5 percent (and from there to 10 percent), a rate that now seems like a distant and unattainable dream.


No one expects a central banker to have completely accurate foresight, however, given that their economic skill sets create the policies that drive the economy, one would think that they would have a better grasp of the potential  medium- and long-term outcomes of a particular policy.  As shown in this posting, that would quite clearly not be the case and Ms. Yellen's 2006 observations about the employment situation in the U.S. provide ample proof that central bankers all suffer from cluster think.