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2017-09-21Macro `n Cheese

The Yellen Chart Pack – and then some…

If you thought it was time for a rethink, think again... The FED is making the same bet over and over

Over the past few weeks, prominent members 1 of the Federal Reserve Open Market Committee (FOMC) have raised their voices on yet again low inflation readings and some of them have, yet again, come to the conclusion that the labor market inflation nexus is not behaving as Federal Reserve (FED) intended it to. Underlying this kind of reasoning is of course the (short run) Phillips curve, which supposedly shows the exchange relationship between (wage) inflation and unemployment rates.

With that in mind, I could not help but to think back a couple of years to when FED chairwoman Janet Yellen frequently returned to a small sub-set of labor market indicators, which she thought were important to the conduct of monetary policy. Looking at those and adding a couple of value added graphs (I am working for Macrobond after all) I thought we could at least try to understand the interaction between labor market and wages and, in the extension, inflation.

1For an excellent overview of current FED-talk please read FED-watcher, par excellence, Tim Duy’s latest:

Macrobond chartMacrobond chart

Figure 1: The labor market inflation nexus is ill-behaved

The prevalence of low inflation becomes even clearer when we perform a principal component analysis looking at the sixteen (no less) most common (well…) inflation measures available for the US economy. The first component (pc1) explains 55% of the variability between the different inflation measures and is assumed to demonstrate the common inflation trend and should be expected to be closely related to labor market (wage) developments. If we add the second component (pc2), which is probably related to food and energy prices, we can explain more than 77% of inflation variability.

The As the chart below demonstrates, the common inflation trend is currently outside (below) the 90% confidence interval (calculated on data since the beginning of the 1990’s). Such a low inflation trend could very well start influencing inflation expectations in a more distinct way, something many FED members are also alluding to. Thus far, though, it seems a stretch to claim that inflation expectations have reacted markedly to the recent weakening of the inflation trend.

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Figure 2: The common inflation trend is no friend of the FED

For current indicators on the demand for labor, Yellen has often been pointing to the “quit rate”, which shows how many that voluntarily leaves employment, indicating if prospects for finding other, more rewarding, jobs are good or not. However, doing some thorough eye-ball-econometric work, it seems as if the so called “hiring rate” is at least as good. The hiring rate expresses how many that are being added to company payrolls 2 and as such a good measure of how eager companies are to fill vacancies and replace quits. Both measures should, thus, be expected to both lead and correlate positively to (wage) inflation.

2 For those of you wondering, the JOLT-survey shows gross hiring/firing, whereas NFP (the establishment survey) shows net hiring.

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Figure 3: Something is rotten in the state of the US labor markets

At times, as the quit rate by itself has provided a misleadingly positive image of the labor market Yellen has expanded on the “Job Openings Labor Turnover” (JOLT) survey and looked at the so-called “Beveridge Curve” instead. The Beveridge curve (BC), of course, shows what unemployment rate we could expect given the level of vacancies (job openings). Thus, it also shows how efficient the matching process is, i.e., if any structural changes have occurred in the demand and supply for labor. As the graph above suggests, it seems as if the matching process has indeed worsened after the great recession (an outward shift in the BC). – Why is that?

The much-discussed labor force participation rate could possibly explain why the BC has not shifted inwards more distinctively over the very last data points (as the participation rate has increased somewhat over the last couple of years), but given the massive decrease in participation rates in the wake of the great recession it is hard to fathom how this could be used to explain the behavior of the BC. We will return to this subject below.

Increased long-term and higher frictional unemployment are probably better suited to explain at least some of the worsening of the matching process as we see increased longevity of unemployment (especially as a share of the unemployed) and a rather high rate of labor market “churn” (demonstrated, i.a., by high hiring and quit rates in the graph above). In addition, the noticeably weaker geographical mobility of the labor force should also explain some of the outward shift in the BC.

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Figure 4: Valid explanations to the outward shift in the Beveridge curve

That said, the lion’s share of the deterioration in the functioning of US labour market, visible in the outward shift of the BC, is probably a demographically induced shift in skills mismatches3. This makes the discussion on the labor force participation rate all the more interesting, since its development is often said to have demographic underpinnings. At face value, a lower participation rate is not consistent with an outward shift of the BC. And when looking at relative participation rates it seems as if the older age cohorts have, if anything, increased their labor force participation. Instead, it is the younger cohorts where the deterioration is most visible.

3 This is the FRBSF-blog post that got the debate started: Both BBG ( and the Economist ( have expanded on this issue

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Figure 5: Indexed labor force participation by age, sex and educational attainment

That said, the first full recovery year after the recession was in 2010, and as can be seen, since then there are two age cohorts, 35 to 44 and 45 to 54 where participation is still lower today, while all other age cohorts currently post equally high or higher participation.

We can also see that people with higher educational attainment have raised their relative participation dramatically, implying that this long term bifurcation trend (pre-dating the crisis) of the labor force is not only intact, but have actually accelerated after the great recession. This, to be clear, implies that labor from all age cohorts with only (and without) a high school diploma are gradually losing connection with the labor market. This does not only explain a decrease in participation rates but could also be used to explain why the LT unemployed becomes a larger share of the unemployed and why the BC has shifted outwards.

Putting the above developments together creates something of a storyline: As the skilled, highly educated and plentiful senior workers of the baby boom years (post WWII) are gradually moving into retirement, their high paying jobs disappear and they are primarily being replaced by lower paid and recently graduated young people (as can be seen in the graph above, the 25-34 cohort has performed well for a number of years). The middle-aged cohorts cannot be expected to fill these gaps since it makes little sense, at least economically, to enroll at college and university at a more mature age. In the extension, this might also explain why the “Okun law”, how changes in UNR affect GDP, suggests both lower trend growth (the intercept) and weaker effect on GDP of increased employment (as the new-entrants sport lower productivity) in the period after the great recession.

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Figure 6: Okun’s rule of thumb not aging with grace

And this exactly what the FED-research cited above suggests; The labor market and wage inflation nexus is mostly intact. The low wage growth is instead due to a compositional effect (exodus of older and high paid middle aged) and once this effect wears off, wage inflation should reappear.

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Figure 7:

At the heart and center of the discussion of the low inflation developments over the past years are labor market developments. After many a discarded hypothesis about the changing behavior of this assumed stable relationship FED has now provided the latest and, hopefully, correct version. In simple terms, the more recent research implies that the enigmatic behavior of the Phillips curve post-crisis is just a temporary phenomenon and that the post-crisis curves in the graphs above will gravitate towards the pre-crisis curves.

Once again, then, we are left with a hypothesis that support monetary policy orthodoxy, cementing the usage of unconventional monetary policies.

I, for my part, am highly dubious of most assumed properties in economics even if I appreciate a hypothesis underlining my own maxim that “economic developments are always and everywhere a demographic phenomenon” (yes, it reminds you of something).

As it happens, one of my favorite papers on the Phillips curve is one pointing to the futility of using this, almost non-existent, relationship at all 4. Furthermore, that paper has something to say for how monetary policy is really working and why I, from a strictly academic perspective of course, look forward to this whole “monetary policy normalization” thing everybody is talking about. Will monetary policy really ever “normalize”? How could it?

4 The easy-read version: The very serious person version:

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