Macro and Markets

The most recent Pew Survey on European attitudes (summary table below) shows that support for the European integration project is dropping.  My colleagues at CFR are far more able than I am to address the broader political ramifications of this shift.  A few points though on the link between economic growth, public opinion, and support for the European reform agenda. Growth matters.  Today’s Eurozone GDP numbers remind us that Europe remains in a grinding recession; a second-half recovery now looks to be a long shot at best.  The only bright spot comes elsewhere, with news of  a German labor deal that will raise engineering wages by nearly 6 percent over the next 20 months (rebalancing European demand and stimulating German consumption needs more of this).  Some of the decline in the Pew numbers likely is cyclical, as declining confidence in their own economic prospects seems to spill over to other issues.  Notably, the need for jobs dominates other issues on the economic agenda.  The mood is particularly bleak in the periphery, reflecting those countries’ economic troubles. This is consistent with the idea the recession and diminishing expectations for the recovery are weighing materially on public opinion. A disillusioned France should matter to markets.  The sharpest decline in sentiment in the survey--both for their own economic prospects and for the EU project--is in France.  This coincides with other reporting suggesting declining confidence in the government’s ability to put the economy on the right track.  In this regard, markets could be sensitive to a rise in opposition to the European project in France.  The right-wing National Front (FN) party headed by Marine Le Pen has announced that it will run in next May’s EU parliamentary elections on a platform calling for an referendum on the euro.  How would markets react if--fueled by disillusionment with the government’s economic program--the FN was the first past the post in those elections? Will a single chart damage Europe’s efforts to resolve the crisis?  I missed this when it first came out, but it’s still worth a look.  Last month, the ECB’s Eurosystem Household Finance and Consumption Survey presented estimates, for households, of median net wealth and the median value of their main residence.  The interesting datapoint:  Germany is at the bottom.  Belgium, Spain and Italy (and, yes, Cyprus) all have household wealth several times German levels. When this was released last month, the German press had a field day with the message that Germany shouldn’t bail out rich southern Europeans.  There was pushback:  it was noted that if means rather than medians were used, Germany would be in the middle of the pack (reflecting a more skewed German income distribution).  Further, the high proportion of renting rather than buying homes in Germany means more housing wealth is off the household balance sheet.  Broader measures of national wealth, including capital, restore Germany to the top ranks in terms of income. The Pew survey (taken before the release of the chart), conversely shows Germans still support the European project, and are willing to pay to support it.  (By 52 percent to 45 percent, Germans support bailouts for countries in crisis, compared to 40 percent in favor in France.)  It remains to be seen, though, whether the chart below and the pessimism reflected in the Pew Survey resonates with less affluent German voters already suffering from bailout fatigue.  

Jaret Seiberg has an excellent summary of Ben Bernanke’s speech and Q&A today on financial sector regulation and reform.  This follows on Dan Tarullo’s speech Friday that highlighted the need for additional capital aginst short-term wholesale funding, an earlier Jeremy Stein discussion on liquidity regulation and the value of price-based regulation (rather than quantitiative limits on bank size favored by some in Congress), and similar comments by the OCC.  We now have as clear a signal as possible that U.S. regulators are ready, in Seiberg’s words, "to go beyond Basel 3 to impose to additional capital requirements on the biggest banks...[using]...a combination of a more restrictive leverage limit, a capital surcharge based on reliance on short-term debt, and a long-term debt requirement." It also underscores the divergent approaches toward reform in the U.S. and Europe, where, against the backdrop of weak growth and credit constraints, the pressures appear to be leading to a slower, more bank-friendly path.

Does the large drop in the U.S. labor force participation rate justify a monetary policy that is easier, for longer, than suggested by our models or the Fed’s current description of its policy?  Chris Erceg and Andy Levin, two senior researchers at the Fed now on leave at the IMF, argue yes.  Their analysis will provide fuel to the monetary policy doves who argue the Fed is failing to meet its employment mandate, and points to a battle ahead.  But it doesn’t really settle questions about whether monetary policy is an effective tool for bringing these workers back into the work force, or whether it can be done without creating inflationary pressure (which speaks to other leg of the Fed’s mandate). Still, their paper is an important read. The unexplained fall in labor force participation Their first chart shows the decline in labor force participation since 2007, both in absolute terms and relative to a Bureau of Labor Statistics (BLS) forecast for the future path of the participation rate made in 2007.  It suggests that the sharp drop in the participation rate since 2007 was unexpected and hard to explain by the structural factors that affected participation in the past such as the aging of the population, or shifts in specific groups such as female or youth workers.  This means that the gap between the two lines, the "participation gap," must be cyclical--the result of the great recession--or because of some new structural factors that the BLS didn’t anticipate.   The structural argument deserves some elaboration.  Recall that labor force participation actually peaked around 2000 and was on a downtrend even before the great recession (see next chart). One view is that this means there are even more "missing workers" put out of jobs, involuntarily, by the weak recovery of 2000-07.  I think a better explanation is that there were already structural changes underway in the workforce that are not captured by the BLS forecast.  From this perspective, the great recession is an accelerant that forces change (eg, in terms of labor-saving by firms, changes in long-term competitiveness, or changes demand for skills) that had been building already.  Whether you want to describe this as cyclical or structural, these workers may not be easily brought back into the labor force through expansionary macro policies.   Civilian Labor Force Participation Rate, 16 and older Source: BLS This next chart from Erceg and Levin shows that the participation gap (derived from the first chart)-- the orange dotted line--now exceeds the gap between current unemployment and the long-run unemployment rate (the purple line).  It shows that the participation rate adjusts more slowly than the unemployment rate.  It also highlights the amount of slack that needs to be absorbed is potentially much larger than suggested by the unemployment rate alone. The bulk of the Erceg and Levin paper then addresses two critical questions:  Is this structural or cyclical? And will it persist as the economy recovers (and the unemployment rate drops)?  On the question of cyclicality, the paper looks at a cross-section of state participation rates during the recession (see below).  States with the deepest recessions had the sharpest fall in unemployment, which they argue suggests it’s weak demand that is driving much of the recent decline in participation.  State data has been criticized in the past as subject to noise and error, and others suggest that looking at flows into and out of the labor force is more consistent with a structural explanation.  In any event, this result is central to the debate over whether ’this time is different’ because the post-war experience has been that participation is largely non-cyclical. The Fed’s employment mandate "The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates." (Federal Reserve Act, 1977) The Fed is unusual among central banks in having a statutory dual mandate to ensure both maximum employment and stable prices.  The Fed has long stressed that in most circumstances these two objectives are consistent, and further that it looks at a wide array of indicators in fulfilling its mandate.  However, much economic theory, and the Fed itself, have put the spotlight on the unemployment rate (and its relationship to the longer run, normal rate of unemployment) as the most important single metric of labor conditions.  This focus has intensified since the Fed, in December 2012, announced that an unemployment rate of 6.5 percent would serve as a threshold (not a trigger) for tightening policy from the current near-zero levels. The dilemma for the FOMC is how to react if the unemployment rate declines to below 6.5 percent while the participation rate remains low.  Should we look at the sum of the unemployment and participation gaps as the measure Fed policy must address?  In assessing this argument, the Fed will have to answer three questions in particular: How low can the unemployment rate go before inflationary pressures emerge? The Fed’s estimates of the central tendency for the longer-run, normal unemployment rate, at 5.2-6 percent, is substantially higher than they forecast several years ago, reminding us of the inherent uncertainty in these traditional macro relationships. Does a high participation gap put downward pressure on inflation?  Certainly inflationary pressures remain muted, even too low (recent work by Lars Svensson and others suggest inflation below 1 percent can be distortionary and undermine a credible central bank’s policy).  But the great recession also has undermined notions of a tight relationship between slack in the economy and inflation (inflationary expectations haven’t moved very much with the recession) suggesting the need for caution during the upturn as well.  Does the existence of a pool of workers that have left the workforce, for example to retire or to go to school because there are limited job opportunities, put downward pressure on the wages of those who have jobs? Is monetary policy the right tool to address the participation gap? Recent research on long-term unemployment suggests that, once workers are unemployed more than six months, their connection to the work force become tenuous.  In such cases, even if their exit was the result of a demand shock, at some point they lose the skills, the connectivity, and the resume to reenter easily. What starts as cyclical becomes structural.  Monetary policy may be a blunt tool for addressing the participation gap, suggesting targeted fiscal policies (e.g., job retraining and employment subsidies) may be more effective tools.  The monetary policy dove will argue that absent fiscal policy, monetary policy is the best tool in the toolbox, while critics will weigh these potentially modest benefits against the cost of an even larger balance sheet. None of these questions have easy answers. Erceg and Levin are careful to emphasize the limits of their analysis.  But their work, and the notion that the Fed needs to target policy to reduce this gap, may be front and center at future FOMC meetings.