Federal Reserve’s Dual Mandate Disappointment; Will Private Investment Clean Up Slack? [Dow Jones Industrial Average, S&P 500]

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July 11, 2014 11:31am NYSE:DIA NYSE:SPY

Federal reserveJonathan H. Todd: In the June 2014 Federal Reserve Open Market Committee minutes, the board decided to cut the current quantitative easing program altogether by October, indicating that perhaps, after several years of halting asset purchase programs


, the economy is finally ready to fly on its own.

The Federal Reserve, of course, has a dual mandate – with an inflation target to manage prices and to maximize employment. By their own admission, however, the economy is lagging behind in both counts.

First, on prices, inflation is still running below the 2% target. The minutes say,

Readings on a range of price measures–including the PCE price index, the CPI, and a number of the analytical measures developed at the Reserve Banks–appeared to provide evidence that inflation had moved up recently from low levels earlier in the year, consistent with the Committee’s forecast of a gradual increase in inflation over the medium term. Reports from business contacts were mixed, spanning an absence of price pressures in some Districts and rising input costs in others. Some participants expressed concern about the persistence of below-trend inflation, and a couple of them suggested that the Committee may need to allow the unemployment rate to move below its longer-run normal level for a time in order keep inflation expectations anchored and return inflation to its 2 percent target, though one participant emphasized the risks of doing so. In contrast, some others expected a faster pickup in inflation or saw upside risks to inflation and inflation expectations because they anticipated a more rapid decline in economic slack.

Second, on employment, the unemployment rate has fallen to a 20-year average, which is encouraging, but the underlying numbers still show softness in the labor market, especially with respect to labor force participation and wages. On the secondary employment gauges, the statement says,

In assessing labor market conditions, participants again offered a range of views on how far conditions in the labor market were from those associated with maximum employment. Many judged that slack remained elevated, and a number of them thought it was greater than measured by the official unemployment rate, citing, in particular, the still-high level of workers employed part time for economic reasons or the depressed labor force participation rate. Even so, several participants pointed out that both long- and short-term unemployment and measures that include marginally attached workers had declined.Most participants projected the improvement in labor market conditions to continue, with the unemployment rate moving down gradually over the medium term. However, a couple of participants anticipated that the decline in unemployment would be damped as part-time workers shift to full-time jobs and as nonparticipants rejoin the labor force, while a few others commented that they expected no lasting reversal of the decline in labor force participation.

On wages, the Federal Reserve minutes say,

Aggregate wage measures continued to rise at only a modest rate, and reports on wages from business contacts and surveys in a number of Districts were mixed. Several of those reports pointed to an absence of wage pressures, while some others indicated that tight labor markets or shortages of skilled workers were leading to upward pressure on wages in some areas or occupations and that an increasing proportion of small businesses were planning to raise wages. Participants discussed the prospects for wage increases to pick up as slack in the labor market diminishes. Several noted that a return to growth in real wages in line with productivity growth would provide welcome support for household spending.

Prices and employment/wages are interlinked, of course – as the labor pool deepens, as it did in the aftermath of the 2008 Great Recession, wages go down. In the ensuing recovery, wages have not grown at any sort of robust pace, suggesting that the pool of workers is still deep enough to suppress wages of employees.

This week’s JOLTS reading was encouraging, however, as job openings per unemployed worker was at its lowest level in years – 2.1 unemployed persons per job opening, down from the July 2009 peak of 6.8. That is, companies have fewer hiring options, so they will have to increase wages to sweeten the deal to entice workers to their firm.

So while there are encouraging signs in the economy that the employment and inflation rates will be up to snuff, as far as the Fed is concerned, they are still lagging behind on both counts. So why cut asset purchases? Haven’t we learned that ending asset purchase programs too soon is a surefire disastrous decision (See QE1, QE2)?

Maybe not. One of the biggest headwinds in the economic recovery have been the lack of investment from both businesses and households, but that might be changing soon. With respect to investment, the Fed states,

Information from participants’ business contacts suggested capital spending was likely to increase going forward. Contacts in a number of Districts reported that they were generally optimistic about the business outlook, although in a couple of regions respondents remained cautious about prospects for stronger economic growth or worried about a renewal of federal fiscal restraint after the current congressional budget agreement expires. Among the industries cited as relatively strong in recent months were transportation, energy, telecommunications, and manufacturing, particularly motor vehicles. Some participants commented that their contacts in small and medium-sized businesses reported an improved outlook for sales, and several heard businesses more generally discuss plans to increase capital expenditures. One participant noted that District businesses were investing largely to meet replacement needs, while another suggested that the backlog of such needs would likely provide some impetus to business investment.

This fits with the data that shows that America’s capital stock is has been aging and quickly in need of replacement. According to BEA data, the average-age of private fixed assets has risen for nearly all segments since 1980, though especially households and sole proprietorships. (except farms, incidentally enough) since the financial crisis. Between 2007 and 2012, the age of fixed assets for nonfinancial corporations rose from 7.9 years to 8.5 years, while households saw a jump from 11.4 to 14.3.

Assets for private owners are generally rotting like old tree stumps. Source: Bureau of Economic Analysis

However, if these companies and homeowners want to continue functioning as a going entity – that is, for businesses to sell their goods and services, and individuals to be able to do things like drive themselves to work or live in a functionally operating household – they’ll have to make capital investments on fixed assets. This all ignores the public investment needed for things like infrastructure that have gone largely ignored in recent years, which business owners are obviously concerned about.

So while the employment and price data show a still-soft economy, perhaps the Fed suspects that the increased savings that have been accumulated recently will be put to work in the economy soon, which will will solve in Fed’s own dual-mandate goals.

This article is brought to you courtesy of Jonathan Todd.


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