Cyclical vs. structural labour market issues and the Fed

Markets have been increasingly concerned with the prospect of the slowdown of asset purchases from the Federal Reserve, with bond markets selling off, the US dollar a little stronger, gold markedly lower and equity markets a little more subdued (although still climbing).

A hawkish article from John Hilsenrath from the WSJ, often seen as an unofficial mouthpiece of the Fed, has triggered some of the change of mood in recent days, but more important has been the somewhat better employment data over the past 6 months.  Non-farm payrolls have risen by an average of 200k+ in the last 6 months, and the unemployment rate has dropped to 7.5%.

Given this is a meaningful step towards the 6.5% rate that the Fed has flagged as a point at which it would consider raising rates, such an apparent improvement should rightly give markets pause for thought as to whether QE should be dialled back.

Whether this rate of improvement in the unemployment rate continues not only depends on job creation, but also whether labour force participation changes.  To be sure, labour force participation has dropped dramatically, particularly in the 25-54 age category, which has been stable for a very long time prior to this great recession.

One argument could be that the severity of this recession has created a structural change in labour participation, and these people will never come back to the labour force.  Alternatively, it may be more of a function of weak labour demand, with the drop in participation more to do with a very severe cycle rather than a structural change.

This research by Fed economists suggests its the latter rather than former based on regressions of state-based data, which show a large degree of divergence.  And this seems like the that is the way the key members of the FOMC will lean.  To be sure, the structural vs. cyclical unemployment debate came up for debate in the FOMC back in 2010.  While markets saw comments around the issue of structural job mismatching as hawkish, it was ultimately sunk by Chairman Bernanke's view of research to the contrary.

A more controversial implication of this research is the idea that policy makers should design policy so that unemployment rate is allowed to overshoot "maximum employment" (level of employment at which inflation does not accelerate).  Similar arguments have been made for inflation, but the Fed seems to take a more conservative view on this.

The implication of this is that despite a drop in the recent unemployment rate, the Fed is unlikely to be convinced that we are getting any closer to the "maximum employment" part of its mandate.  To be sure, unlike inflation, the Fed does have more wriggle room as to where it believes maximum employment is.  Despite talking about a 6.5% threshold for tightening, it would not be inconsistent for the Fed to change its mind given it has stated that "it would not be appropriate to specify a fixed goal for employment", even though they seemingly have.

So I think that yet again, the Fed is more dovish than markets seem to think.  There seems to be a lot of talk that this is contributing to a stronger USD, but on a US TWI basis it hasn't done very much at all.

Rather it seems that gold has been most affected by concerns about a possible end to QE,  although now it seems that the original investment thesis has been replaced by momentum, which has been bad. Never the less, perhaps a more dovish than expected Fed can stem the outflows from ETFs, which remain large.