When I updated Current Market Tactics yesterday, I mentioned the August 17th speech of the President of the Federal Reserve Bank of Minneapolis, Narayana Kocherlakota. I thought I’d elaborate on it a bit today.
First, Mr. Kocherlakota. He went to Princeton (1983) as an undergraduate, and got a PhD in economics at U Chicago (1987). He taught at a number of places, the last being Stanford and U Minnesota, before being appointed President of the Minneapolis Fed last year.
Mr. Kocherlakota says the speech contains his own views, and not necessarily those of the rest of the Fed. But the Fed routinely uses occasions like this to provide background about its actions or to air its thoughts in a way that can’t draw Congressional ire in the way an “official” position might.
As I read it, the speech has several main points:
1. An economic rebound is under way, although the recovery is unusually slow and accompanied by an unusually low amount of inflation.
2. The labor market is responding only sluggishly to very stimulative money policy. How so?
The Bureau of Labor Statistics has been keeping a tally of job vacancies since December 2000. Older, but less detailed data, are available from the Conference Board for the years 1951 onward. Robert Shimer, an MIT-educated economist teaching at UChicago, has studied the relationship between the vacancy rate and the unemployment rate, publishing the results in an article frequently discussed by the Fed and cited in the printed version of Mr. Kocherlakota’s speech.
Anyway, there’s a stable, inverse relationship between the unemployment rate and the vacancy rate–the higher the unemployment rate the smaller the number or unfilled jobs and vice versa–until mid 2008. Then the relationship breaks down. Over the past year, for example, the number of unfilled jobs the economy has created has risen from 2.34 million (the low point, last July) to 2.94 million this June. But the unemployment rate went up during this time, despite the extra 600 thousand extra open jobs.
The unemployment rate should have fallen to 6.3% over the past twelve months as these new jobs were filled. Why not? Mismatch. “Firms have jobs, but can’t find appropriate workers,” as Mr. Kocherlakota put it. Mismatch can come in different forms: a worker can live in Nevada but the job can be in Florida and the worker may be unable/unwilling to sell his house or otherwise reluctant to move; the worker may be only comfortable with pencil and paper, but the job may require computer literacy; or the worker may hope against hope that his old job will magically reappear rather than starting to retrain himself.
The headline grabber of the speech is the statement that “the Fed does not have a means to transform construction workers into manufacturing workers.” I interpret this as being a strong statement about what it thinks is the problem. But it could equally well be that the Fed just doesn’t want to make specific policy recommendations about, say, housing.
3. The recent Fed decision to reinvest proceeds from mortgage-backed securities into Treasuries accidentally scared the securities markets. The reason the Fed is buying Treasuries is not that the economy is in worse shape than commonly thought, but that mortgage prepayments have been larger than anticipated (because low interest rates have prompted lots of refinancing). Because of this the Fed’s holdings of government securities have dropped below the intended level.
4. The Fed will likely begin to raise rates before the consensus thinks it’s appropriate. Standard economic theory says that money policy actions can have short-term real effects on an economy but that over time the economy adjusts to restore the pervious real status quo. The way this is usually expressed is that an inappropriate drop in interest rates can temporarily boost economic activity in a country but that growth soon moderates and the country is in the same place as before, but with higher inflation.
Mr. Kocherlakota’s point is that the long-term real rate of return on cash-like securities is around 1% annually. If the Fed holds the policy rate at effectively zero after the economy is restored to health, the economy will adjust to restore the real rate to 1%. It can only do this through deflation–by making real prices decline by around 1% a year. Sounds kind of wacky, until you think that this is a good description of what Japan has been doing for the past twenty years.
It seems to me the speech does several things:
–it provides an answer to critics who say that money policy is still too tight, by pointing to the large number of unfilled jobs available. The passage of time will eventually cure the mismatch. Government programs may speed the process up, but looser money policy will just create more unfilled vacancies.
–it implicitly criticizes the notion that more “shovel ready” projects will do any good. Again, Japan’s experience over the past twenty years is a cautionary tale. in 1990, a startlingly high 10% of Japan’s work force was employed in construction. Rather than allow/force a transition to other occupations, Tokyo launched wave after wave of make-work pork barrel public construction projects. The government also used formal and informal means to preserve the status quo in other sectors, in order to keep the unemployment rate low. What did all this get Japan–twenty years (so far) of economic stagnation, chronic deflation, a crippling amount of government debt and a tendency to rue the day that the black ships arrived at its shores.
–it signals to academic critics that it understands the negative implications of keeping the fed funds rate at zero too long.
All in all, the speech is a lot more interesting, and revealing, than the single sound byte.