Back to school – a critical lesson in labor economics

With the end of summer approaching, families have been anxiously preparing for their children’s return to school. Children are not the only ones required to return to an educational institution this fall. As both contributors to and beneficiaries of the global economy, adults are also being schooled in more ways than one.   

The inevitable rise of U.S. interest rates will impact not only investors, but also borrowers, consumers and businesses. The who, what, where and why are known variables. It’s the elusive, yet most crucial “when” that continues to be the topic of debate for policy makers, economists and analysts alike.  

Despite significant improvement in U.S. labor markets, Federal Reserve Bank Chair Janet Yellen is resolute in her view that ample slack still remains. In her most recent speech at the Fed’s annual economic conference in Jackson Hole, Wyoming, Yellen clearly reiterated her view that “underutilization of labor resources still remains significant.” With unemployment at its lowest rate in almost six years and inflation not posing any threat to the economy, what is the Fed waiting for? 

To answer that question we may need to take a ride down the education memory lane – economics class to be more specific. You have probably realized by now that economics is not an exact science. Unlike mathematics, outcomes cannot be predicted with the same precision. Furthermore, economics is the only field where two people can be awarded the Nobel Prize for stating the exact opposite.  

Against that backdrop it’s not surprising to have economists, including some of Yellen’s fellow Federal Open Market Committee colleagues who believe the Fed should raise interest rates sooner rather than later, while others offer strong support for the Fed’s current strategy. 

Undoubtedly, labor conditions in the U.S. have improved. The unemployment rate currently stands at 6.2 percent, down from its recession peak of 10 percent and inching closer to the Fed’s maximum employment goal in the 5.2 to 5.5 percent range. The U.S. economy has also added more than 200,000 jobs per month for the past six months. Additionally, job openings have reached the highest level since early 2001. Fed hawks are therefore confident that the considerable progress achieved in labor markets should provide the impetus to tighten monetary policy.  

Economists in the dovish camp echo the Fed chair’s sentiments and believe there’s a risk of moving prematurely. To make their arguments they point to other less-often cited labor market statistics. Notwithstanding its importance, the headline unemployment number does not single-handedly explain labor conditions. The labor force participation rate, which provides some insight into how many persons have become discouraged and have quit searching for employment, has declined substantially. With only 62.9 percent of the working-age population participating in the labor force, the U.S. has returned to labor force participation rate lows not seen since 1978.  

While part of the decrease can be explained by baby boomers leaving the workforce, there may be other cyclical forces at work. Another indicator on the Fed’s radar is the underemployment rate, which includes part-time workers looking for full-time work as well as those discouraged workers who would rejoin the labour force if a job was available.  

Although this indicator has declined markedly, its most recent reading still came in at 12.2 percent, double the unemployment rate. As a matter of convenience, along with Yellen’s labor market dashboard of nine indicators, the Fed developed a 19-factor labor market conditions index to gauge the strength of labour markets. 

The one gauge, however, that has garnered the most attention from policymakers and workers alike is the lack of growth in wages. The stagnation in earnings provides anecdotal evidence that inflation concerns are unfounded and lends support to the Fed’s current strategy to keep rates near zero for a substantial period. The absence of wage increases also implies that significant slack remains in the economy. This is where the crux of the debate lies. The underlying question puzzling economists is whether labor market indicators are accurately measuring cyclical versus structural changes.  

While policymakers have the benefit of learning from past recessions, changing demographic trends make this recent economic downturn a unique and unprecedented challenge. Regrettably, the Fed’s report card will not be available for some time as this subject spans multiple semesters. Only time will tell whether the Fed deserves an A or F for their timing on policy tightening.  


Disclaimer: The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. The Bank accepts no liability for errors or actions taken on the basis of this information.