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By HaleStewart December 31, 2017 8:03 am
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US Bond Market Week in Review: A Look At the Dissenter's Arguments

            At the last Fed meeting, a majority of Federal Reserve governors voted to raise rates\.  Citing the combination of a strong labor market and the expectation that inflation would return to 2% in the intermediate future, a majority of the board voted to raise rates an additional .25%.  But two governors dissented: Neal Kashkari and Charles Evans.  Each provided a good reason their respective dissent.

            Kashkari argued that the 4.1% unemployment rate concealed labor market weakness, which was evident from weak wage growth.  He cited the still low employment/population ratio and participation rate of the 25-54 year segment of the population as the primary reason for the weakness:

The headline unemployment rate includes only people who are actively looking for work. While 4.1 percent is low by historical standards, the Great Recession pushed many people out of the labor force, some of whom are only slowly reentering. One measure of the labor force — the participation rate for workers between 25 and 54 years old, typically called “prime age” — suggests that there could be more than a million workers still on the sidelines. We don’t know how many will return, but with wage growth still well below its precrisis pace, it’s easy to argue that we might not really be at full employment. If wage growth climbs, I expect to see more people come into the labor force.

Here's the employment/population ratio of the 25-54 year old segment of the job market:

The lowest level this data point achieved in the last expansion was 78.6% -- the level just recently hit by this statistic nearly 8 years after the end of the last recession.  Using the data from the latest report, each .1% increase in this ratio represents ~260,000, meaning an additional 1% increase would translate into ~2.6 million additional employees. 

            According to the participation ratio, this is more than possible:

The participation rate for 25-54 year olds has been as high as 84% at the end of the 1990s.  That statistic is currently 2% lower.  Using the data from the last report, that represents a gap of ~ 5.2 million individuals. 

            Kashkari and Evans both also cited declining inflation expectations.  Here’s Evans’ take:

Real activity in the U.S. is on a solid footing, which by itself would support a further adjustment in policy. Inflation, however, is too low and has been so for quite some time. I am concerned that persistent factors are holding down inflation, rather than idiosyncratic transitory ones. Namely, the public’s inflation expectations appear to me to have drifted down below the FOMC’s 2 percent symmetric inflation target. And I am concerned that too many observers have the impression that our 2 percent objective is a ceiling that we do not wish inflation to breach, as opposed to the symmetric objective that it really is; that is, we would like to see the odds of inflation running modestly below 2 percent equal the odds of it running modestly above over the long run.  

This chart shows the public’s implied future inflation expectations level by subtracting the respective TIPS yield from the corresponding Treasury yield:

In the first half of 2011, the implied 5-year inflation expectation was 2.32% while the 10-year’s was 2.61.  Those levels are now respectively 1.82% and 1.94%.  While this might sound like an academically irrelevant statistic, it’s important because it helps to determine the pace of economic growth.  Suppose you needed to buy an item that was currently $100 but which you believed would increase 10% in a year.  This would make you more likely to buy the good now when it was cheaper.  Now suppose you thought the good would increase to $101 by year’s end.  You’ll feel far less pressure to purchase that good now.  This analogy explains why inflation expectations are so important: if the public thinks prices are increasing at a faster rate, they’re more inclined to make purchases sooner, which helps to increase the pace of economic activity and overall growth.  Declining inflation expectations obviously slow economic activity.

     A majority of Fed governors still believe in their models, all of which predict a strong relationship between low unemployment and prices.  In other words, the Fed's predictions are based on the assumption that the Phillip's curve still works.  Unfortunately, the Phillip's curve has grown flatter during this expansion, taking some of the of wind out of the Phillip's curve sails.  This makes the dissenter's perspective that much more important.  

In 2009, F. Hale Stewart, JD. LL.M. graduated magna cum laude from Thomas Jefferson School of Law’s LLM Program.  He is the author of three books: U.S. Captive Insurance LawCaptive Insurance in Plain English and The Lifetime Income Security Solution.  He also provides commentary to the Tax Analysts News Service, as well as economic analysis to TLRAnalytics and the Bonddad Blog.  He is also an investment adviser with Thompson Creek Wealth Advisors. 


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