Gavyn Davies on Bernanke’s change of heart

keeping inflation low

Since the tenure of Paul Volcker began over thirty years ago, the mantra of the Federal Reserve has been to do what is necessary to keep inflation under control.  Over time, this morphed into the narrower target of keeping inflation under 2%, but the intent has always been to drive inflation lower.  Yes, the Fed has a “dual mandate,” both to conduct monetary policy in a way to achieve maximum sustainable GDP growth and to promote employment.  But the former has invariably trumped the latter.

…until now

In the September 12th pronouncement from its Open Market Committee, the Fed unveiled new monetary stimulus measures targeted at reducing unemployment.  For the first time, they are open-ended both in terms of time and of money.


…especially when there’s a lively debate, even within the Fed, over whether we are in fact already at full employment.  If so, the new measures won’t create any new jobs.  It will only ignite wage inflation, as companies poach employees from rivals in order to expand.

Personally, I don’t know.  I think that if the Fed decision has any immediate implications for financial markets, they’re positive for stocks and neutral (at best) for bonds.  So arguably as an equity investor, I don’t need to know.

Still, I’m curious.  The best I can do is to fall back on the old saw that inflation is better than deflation, since the world’s central bankers have plenty of experience dealing with the former but have gone 0-for when confronted with the latter.

the Davies answer

Gavyn Davies, former chief economist for Goldman Sachs and now a blogger for the Financial Times, has a better answer in his 9/16 post for the newspaper.  It’s worth reading.

The thrust of the post is that, in Davies’ view, Mr. Bernanke’s QE3 decision implies he believes the US is at a tipping point with the chronically unemployed.

As workers remain out of the workforce, the theory goes, their skills gradually erode–and, with them, their chances of finding new employment.  At the same time, former workers’ enthusiasm for the job search effort also wanes.  Eventually, they drop out of the workforce permanently–becoming unfulfilled as persons, burdens on the rest of society for decades and–crucially–inhibitors of future GDP growth.

Recent surveys by the Labor Department suggest the “dropout” rate in the US is starting to accelerate, putting into motion the downward spiral just described.  In Davies’s view, this is what has changed the balance of risks in the Fed’s mind.

care for a Beveridge? … a curve, that is.

the Beveridge curve

This is a new one for me.  …and I thought I had seen most basic macroeconomic relationships.

The Beveridge curve is named in honor of a British economist, William Beveridge–although he didn’t develop it himself.  It maps the relationship between the unemployment rate and the job vacancy rate (number of unfilled jobs as a percentage of the labor force).

The relationship is inverse:  the higher the unemployment rate, the lower the percentage of vacant jobs should be; the lower the unemployment rate, the more likely it is that jobs will go at least temporarily unfilled–therefore raising the vacancy rate.

why is the curve important?

I found out about the Beveridge curve from a post written by Gavyn Davies, former head of the global economics department for Goldman, on the blog he writes for the Financial Times.  The post is titled “Why the Fed has taken QE3 off the agenda.”

It gives two important reasons for thinking that further quantitative easing is unlikely in the US.  One of these is the current behavior of the Beveridge curve.

In illustration, Mr. Davies prints a pair of charts which he’s borrowed from an economist from Barclays Capital, Peter Newland.  They depict the job vacancy rate on the vertical axis and the unemployment rate on the horizontal.

The first chart demonstrates that the current Beveridge curve is different from the pre-recession one.  The curve has shifted substantially to the right since 2008.  The present job vacancy rate would have been associated with a 5.5% unemployment rate less than a decade ago.   It’s now associated with an 8%+ unemployment rate.

Both Mssrs. Davies and Newland appear to believe that this shift is a permanent change.  In support of this idea, Mr. Newland’s second chart shows that a similar phenomenon occurred after the first oil shock in 1973-74, which triggered the worst post-WWII recession the world had seen until the recent Great Recession commenced.  So an outward shift of the Beveridge curve during a time of great economic change has already occurred before.

The conclusion they draw is that the current 8% unemployment rate is the functional equivalent of the pre-recession 5.5%.  If they are correct, and I think they are, today’s shifted Beveridge curve signals that we’re much closer to full employment in the US than the raw unemployment data would suggest.

This is important.

At full employment, monetary easing doesn’t create new jobs–there’s no one with the skills needed to fill them.  Instead, all loose money does is create a potentially damaging inflationary wage spiral as bidding wars break out to lure already employed workers from one firm to another.  Therefore, QE3 won’t happen.

another reason QE3 is off the agenda:  labor force participation rate

The labor force participation rate is the percentage of people of working age who are actually in the labor force–that is, either employed or willing to/looking for work.  What’s left over includes homemakers and students, among other groups.

One other group of non-participating persons of particular economic concern are so-called “discouraged workers.” These are people who have lost heart because they can’t seem to find a job and have ceased to look.  Although without jobs, they disappear from the unemployment statistics.  But they still lurk in the shadows, as it were, waiting to reenter the workforce when they conclude their chances they’ll find a job are more favorable and start looking again.

A quick look at the labor force participation rate suggests there might be a lot of discouraged workers.  The rate during 1998-2001 was 67.3%.  Now it’s at 64%.  Where did all those other 3.3% go?  Are they discouraged workers?

The short answer is “no.”

Mr. Davies cites a recent study by the Chicago Fed which concludes that the largest force behind this decline isn’t workers being discouraged by recession.  Rather, it’s a natural falloff in participation owing to the aging (and retirement) of the Baby Boom.  The Chicago Fed predicts that by 2020 the labor force participation rate will be lower than it is today, for the same age-related reasons.

Why is this important?  It, too, suggests that, with no gigantic pool of discouraged workers to fall back on, we’re much closer to full employment than the raw data would lead one to believe.

my thoughts

I’m solidly in the structural unemployment camp.  The wage increases for workers that we’re just beginning to see are further evidence that the US is running out of suitable candidates for jobs available.

Chronic unemployment is a terrible social problem.  But it can only be fixed through retraining and through continuing unemployment benefits.  Accommodative money policy won’t help.  Make-work infrastructure spending programs won’t do anything, either.   Facing a similar situation in 1990, Japan launched a series of massive public works construction projects, whose sole impact has been to mire that country more deeply in debt.

The bottom line is that the present loose money stance isn’t likely to last until late 2014, in my opinion.