Economic Commentaries


The Federal Reserve has clearly enunciated its guideposts for the beginning of a change in its open ended asset purchase program. A 6.5% jobless rate and a 2.5% inflation rate are the thresholds, and progress toward these goals is captivating the imagination of financial markets. Of the two benchmarks analysts have been intensely focused on the labor market because the jobless rate has fallen more quickly than many including the Federal Reserve had forecast and because trends in jobless claims have been toward improvement.

Focus on the jobless rate is not without caveats, though, of which Federal Reserve officials are well aware. An important reason for the decline in the jobless rate over the past few years has been a downtrend in the labor force participation rate. And if this were to continue the jobless rate could fall without an underlying improvement in the labor market. A shift from full time to part time employment has a similar effect. And this could become important since the Affordable Care Act is giving employers an incentive to adjust hours worked. Meanwhile, in the public sector the sequester is causing workers to be furloughed rather than be dismissed.

The Congressional Budget Office is estimating that approximately 700K jobs will be lost because of the sequester. Furloughs probably make this an overstatement but even if the estimate is half right it will impose an upward bias on jobless claims in coming weeks and a downward bias on payrolls. Meanwhile, the economy's overall momentum may be about to slow as inventory rebuilding is completed. Finally the spring is a seasonally strong period for hiring so any drag on hiring would exaggerate the weakness.

Inflation is the other component for Federal reserve policy. It has been ignored because by every measure it is well below the Fed's threshold. But what if inflation falls even further. After all, wage pressures are anemic; the dollar exchange rate is strong; the downtrend in commodity prices is well established; and gasoline prices are easing aseasonally. Beyond these rents, which have imparted an upward bias to inflation over the past year, may be about to reverse. With foreclosed properties now turning into rentals, supply is increasing and rents are slowing. So what was an upward bias to inflation will become a downward bias.

If economic growth and the job market slow simultaneously while inflation drops, thoughts of downside risks to the business outlook will begin to percolate. Suddenly current Federal Reserve policies would be deemed appropriate if not too timid. This would allow the Fed additional leeway in conducting monetary policy and the end date for the asset purchase program would undoubtedly be pushed further into the future. How equity markets would react to such a circumstance is debatable, but fixed income markets would be expected to react positively with long term rates falling and the yield curve flattening.

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