We thank readers for comments on our Sunday morning piece about the Fed and the risk of policy mistakes. For those who missed it, the link is here: http://www.cumber.com/fed-employment-mistake-or-correct-munis/. For those who missed my colleague Bob Eisenbeis’s piece on Fed policy, here’s the link: http://www.cumber.com/may-fomc-decision/.
Bob raised a technical question internally, which we will share with readers.
Before we do that, however, we want to offer an opportunity to readers and others who may have an interest in joining a “Camp Kotok” gathering in Maine. For years we have received emails asking, “How do I get to go to one of these gatherings?”
So here is your chance. The weekend after Father’s Day has some open spaces (June 21–24, with early bird arrival June 20 and late departure June 25). And Labor Day weekend also has some spaces. Both are over half full. Some folks bring partners, spouses, sons and daughters, or grandkids) to either of these. They are relaxed groups of interesting people who enjoy the conversations and the pristine environment at Leen’s Lodge. These two gatherings are now open to readers on a first-come, first-reserved basis. Go directly to Scott Weeks, owner and manager of Leen’s Lodge, if you want details. You can reach him at 207-796-2929, or you can check out their website at www.leenslodge.com. You may want to use the phone first to obtain a registration passcode and discuss any details or have questions answered. Email me if you have any questions.
Now let’s return to labor-force, debt, and Fed-policy issues.
Bob Eisenbeis weighed in on the unemployment questions addressed by Philippa Dunne and Doug Henwood in our Sunday morning piece:
“I have long argued that looking at new claims without reference to the size of the labor force gives a misleading picture. Yes, the number of initial claims in relation to the size of the labor force is at a historical low. But on the flip side, if the economy created jobs at the same rate today that it did between 1960 and 1970, the jobs number should be four times what it is. Similarly, moving the reference date to 1983–2006, the number should be two times what it is now.”
My conversation with Philippa Dunne focused on the falling labor participation rate. Why is it falling? Where is it headed? I asked if we could see an unemployment rate below 3% while the participation rate trends down to 60%. Those would be remarkable numbers. Ten years ago we would have thought them impossible. Now we are getting close. So, at the suggestion of Bob, we went digging deeply into the weeds. Our effort yielded some interesting numbers.
Readers are invited to look at the changes in the labor force participation rate when examined by gender and by age. The changes are revealing. Folks above 50 have a rising participation rate while young folks have a falling rate. Here is the link to the fully detailed table at the Bureau of Labor Statistics: https://www.bls.gov/emp/ep_table_303.htm.
Bob and I considered this question: How can we measure something (like the U3 Unemployment rate) and base policy on it when we do not understand what is going on? (I’m referring to the shift in the participation rate for those above age 55.) Here’s Bob’s observation:
“Men have been slipping from the labor force since the end of WWII while Women were entering and then began to slack off – not just after the financial crisis but long before 1998. There are a lot of explanations, but there doesn't seem to be a “natural participation rate,” hence all the demographic explanations.
I add more questions. Do those trends mean a guaranteed rising inflation rate and acceleration of higher successive price level changes? The answer may be no. If the participation rate is rising among the over-50 demographic, does that change the way we think about rising wage pressures? Are older workers more productive, more reliable, less prone to changing jobs, more inclined to company loyalty? There are a lot of questions without answers. Is the Fed asking them? Shouldn’t the questions be examined first, before setting a policy based on an unemployment rate that is low because the participation rate is falling? Bob Brusca notes how the unemployment rate would be somewhere between 8% and 9% if the participation rate were held constant.
On a separate note we ask if the federal debt burden is deflationary. Maybe it has a suppressive effect. Barry Bannister (Stifel) has long argued that the ratio of incremental economic growth to incremental debt has been falling for years. He notes that it takes more and more units of debt to add a unit of GDP. That’s something we must think about as the federal debt explosion looms. The debate on this item is about direction of causality.
Debt is a burden; that seems to be intuitive. In the case of the United States, debt service payments do not reduce the principal owed. It is the interest burden in the federal budget that matters, and it is rising and accelerating. So after ten years of near-zero rates and after ten years of refinancing the nation’s mortgage, the trend is now higher and higher debt-to-GDP and rising interest rates as the debt rolls over. My friend John Silvia (Wells) raised the issue succinctly:
“Rising interest rates would only put further pressure on the federal budget in the years ahead. The question of how Treasury will finance its borrowing needs is not likely to go away anytime soon.”
If we assume for a moment that the market is currently pricing in a reduced rate of Fed hiking, we start to see how all this makes sense. The Fed says one thing, but they are able to respond to incoming data when they don’t get what they expect. The market thinks the Fed’s forecast path for interest rates is too aggressive. So the market says that the Fed will eventually realize its error and alter that path. That is why the market-based expectations of future rising interest rates are lower than the Fed’s assumed narrative. It is also the reason why the forward rates suggest that the Fed will not tighten as quickly as the Fed’s narrative says. And it helps explain the flattening of the yield curve.
Maybe, just maybe, the present policy is on a three-pronged tightening course, not a single-pronged approach of raising the fed funds target rate. The three prongs are (1) rising short-term policy interest rate (fed funds target); (2) balance sheet shrinkage, which is transferring holdings by the central bank back to the markets; and (3) the intersection with policy of the increasing issuance of Treasury debt as federal deficit financing needs reach the markets.
We wonder if policy rates as defined by federal funds and IOER may be too high. We believe that the Fed’s balance sheet shrinkage pace may be too fast? Why do they have to shrink it at all? There are four elements at work now with Fed policy. Bernanke has noted the first element, the worldwide demand for US currency. He said that the Fed will eventually be enlarging its balance sheet as the demand for currency continues to rise. The second element is the US Treasury, since the Fed acts as the Treasury’s bank. Treasury’s balance at the Fed continues to rise over time as the US economy grows. Note that a rising Treasury balance held at the Fed means a shrinking balance of bank reserves. The third element is technical: The use of RRPs continues to rise, and there is no reason to believe that trend will not continue. The fourth element is also on autopilot: Excess reserves in the banking system grow into required reserves over time as the nominal US economy gets larger.
So what’s the argument for shrinkage versus just stabilizing, rolling debt, and waiting patiently? Also, does a stronger dollar hurt or help? Is the dollar’s strength due to relative interest rate levels around the world and policy differences among major central banks? Is the Fed actually making the growth outlook worse? And lastly, does the looming deficit financing need pile onto a two-pronged Fed policy, effectively creating a three-pronged monetary tightening regime?
Now, we do not know the answers to these questions. We gather in Maine and discuss them in great detail and do so in the context of views on politics, governance, and diverse economic perspectives. And we also worry about policy mistakes. We think the Fed should be worried, too.
Let’s close with an excerpted quote from the now publicly released FOMC minutes of April 28-29, 2009. We suggest readers think back to that financial crisis period of time. Then read this statement in the context of today and wonder if the Fed should really read now and consider it just as applicable as it was then. A few years from now we may see if this Fed has done that and heeded their historical warning. Readers need only substitute the words “balance sheet shrinkage” in place of “asset purchases”.
“Under the current policy approach, the scale of asset purchases and demand for Federal Reserve liquidity and credit facilities, given their terms and conditions and the evolving financial and economic conditions, will drive the size and composition of the Federal Reserve’s assets and the quantity of liabilities. The composition of those liabilities will be determined primarily by the evolution of currency demand and other factors on the liability side of the balance sheet, with reserve balances determined largely as a residual. The balance sheet projections are “bottom up” forecasts based on assumptions about the various components of the balance sheet. We should emphasize at the outset that all of our assumptions, and therefore the resulting projections, are subject to significant error. The significant uncertainty surrounding the outlook for the economy, the uncertain response of users of Federal Reserve credit to the state of financial markets and the economy, and the fact that some elements of the balance sheet are policy choices make these projections more judgmental than typical forecasts.”
David R Kotok
Chairman & Chief Investment Officer
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