There may be more to unemployment numbers than meets the eye. Conventional wisdom has it that as the economy rebounds and jobs are created, people begin to reenter the labor force, making the unemployment rate a particularly stubborn number on the way down. However, changing labor force demographics have upended that wisdom and, we think, the relative stickiness of the unemployment number. As it turns out, much of the decline in the labor force participation rate has more to do with aging baby boomers and a plateau in the rate of women entering the workforce than any cyclical factors specific to this expansion. In the context of the Fed’s forward guidance thresholds established in December, we think this has meaningful implications for the quantitative easing program and portfolio construction.
Last December, we calculated that monthly job growth, while anemic, was sufficient to reach the Fed’s 6.5% unemployment target within 18 months. Since the start of the year, the economy has generated an average of 195,000 new jobs, while the unemployment rate fell from 7.9% to 7.5% over the same period. The seemingly big drop in unemployment is largely attributable to that fact that labor force participation declined over the same time period. While typically a cyclical phenomenon, the long-term trajectory of this trend is telling; the participation rate has been in fairly sharp decline since the late 1990s.
When broken down by previous cycles (upon which the conventional wisdom is based), expansions in the 70s, 80s and 90s, exhibited increasing employment populations and participation rates that coincided with falling unemployment. This was in large part thanks to the long-term trend of baby boomers and women entering the workforce. The most recent two cycles, however, show a reversal of those demographic trends and a subsequent decline in participation rates, despite job creation.
This means the typical slow march toward full employment may not be as slow as it has been in the past. In fact, assuming a fairly conservative participation rate at the current 63.2% and nominal population growth, the economy would need to produce less than 200,000 jobs a month to reach 6.5% unemployment within 14 months. And that’s assuming the participation rate stays constant! If the rate continues to decline – as it has for the past 12 or so years – that monthly number plunges; at 63% participation, for example, monthly job growth can be a meager 161,000 to reach the Fed’s threshold in 14 months.
What does this mean? The Fed didn’t pick this measure of employment by accident. It was looking to replace its previous date guidance with specific conditions for exit from its current extremely accommodative policy for a number of reasons we discuss here. Moreover, we think it mimics the early stages of Japan’s exit from its own quantitative easing program in the mid 2000’s. Like the Federal Reserve, the Bank of Japan (BOJ) had committed to holding rates down for an extended period of time. One of the most challenging issues facing the BOJ was how to shorten the market’s expectations about the duration of ultra-low rates so as to avoid drastic shifts in the yield curve that could have jeopardized the recovery. To deal with this issue, the BOJ introduced its own threshold target for inflation; the thinking was that improvements in the inflation outlook would contribute to a more gradual reduction in the perceived duration of low rates.
We suspect the Fed’s intent behind forward guidance thresholds is the same and will have a material impact on the shape of money in the coming year, both in terms of the market’s perception of the Fed’s stance on monetary policy as well as the shape of the yield curve. By the time the BOJ raised overnight interest rates in July 2006, market participants had already built in much of the rate hike expectations throughout the term structure of the yield curve. A successful Fed communication policy should effect a similar, gradual shift up in the yield curve, taking some of the “belly” out of the middle of the curve and making interest-rate normalization at the short end of the curve less disruptive:
Most importantly, far from ‘beginning to map out an exit,’ we believe this communication strategy is an early part of the road map. In other words, these communication tools are inseparably linked to the Fed’s exit strategy and should be perceived as the leading edge of the end of quantitative easing. In the case of Japan, the process took the better part of four years. As we discussed recently, we believe the targets the Fed has chosen are guiding toward a more compressed time period. The point isn’t when we hit those thresholds as much as it why the Fed may have picked them.
From a portfolio positioning perspective, this will be impactful for a number of reasons. The obvious effect on bonds and the need to tilt away from certain types of duration has been well discussed by now. More broadly though, Fed policy as impacted nearly every asset class (by design), and from a risk -factor standpoint we are focused on the presence of excess liquidity underlying most traditional asset class buckets. We view volatility as the flip side of the liquidity coin – when liquidity dries up, volatility tends to rise – and are mindful to be using strategies (particularly on the defensive side of portfolios) that are adept at exploiting volatility.
We’re also of the mind that the Fed will continue with its ‘credible promise to be irresponsible’ and will keep the QE spigot open to varying degrees even as we approach the policy thresholds. We discussed this so-called “Woodford Period” in a recent communication. In this sense, monetary policy in the context of an improving economy could continue to be supportive of equities and credit even as longer-term nominal interest rates creep up.