Bates Research - 12-20-13
Federal Reserve Tapering
This last Wednesday the Federal Reserve announced that it would begin tapering its purchase of securities, winding down the third round of its quantitative easing program (QE3) that commenced in September of last year. Starting in January of the new year, $75 billion in security purchases a month will become the new standard, a $10 billion reduction. Both Treasury and Mortgage-Backed purchases will be reduced by $5 billion each, down to $40 billion and $35 billion respectively. This move is consistent with previous Fed statements, but may not be ideal for the current U.S. economy.
In a June statement this year, Federal Reserve Chairman Ben Bernanke indicated that based on the members forecasts for unemployment, that he expected the Fed to discontinue its asset purchases around mid-year 2014, with unemployment (measured by U-3) around 7%. The Federal Reserve has been purchasing approximately $85 billion a month in bonds (Treasury and MBS), and even the suggestion of easing back from that figure roiled fixed income markets earlier this year. At the time of the announcement, Chairman Bernanke also noted that this timetable was subject to revision based on the incoming data on the state of the economy - potentially accelerated by a positive economic performance, or delayed by a negative one.
Unemployment currently stands at 7% (seasonally adjusted, month end November), hitting the mark outlined by the Federal Reserve, and down from 7.8% at the end of November 2012 (see Chart below). Inflation (as measured by core PCE, the Fed's preferred measure) remains worryingly low with the latest data available showing a rate of 1.11% as of October, well below the 2-2.5% range that the Fed had targeted. In fact, core PCE has fallen from 1.76% as of October 2012, a rate which itself was already below the targeted threshold, hardly a sign of an overheating economy. This suggests that the economic picture may not actually be improving in the way that the unemployment rate indicates, so how should markets react to Fed tapering?
While the headline unemployment numbers seem encouraging, we can do a little more digging and uncover an alternative story as to why the rate is falling, even if more people are not working. The Bureau of Labor Statistics (which compiles this and other metrics) separates the U.S. population into three categories; employed, unemployed and not in the labor force. In their own words "People with jobs are employed, people who are jobless, looking for jobs, and available for work are unemployed, people who are neither employed nor unemployed are not in the labor force." It's that last category that is going to turn out to be very important. Using these three categories the BLS attempts to classify "... each person age 16 and over who is neither in an institution (for example, correctional facilities and residential nursing and mental health care facilities) nor on active duty in the Armed Forces is counted and classified in only one group." The unemployment rate is a ratio - the number of unemployed persons divided by the total of all employed and unemployed persons (also called the civilian labor force).
The numerator of the ratio is the total number of unemployed persons, which is defined as "All persons who had no employment during the reference week, were available for work, except for temporary illness, and had made specific efforts to find employment some time during the 4 week-period ending with the reference week. Persons who were waiting to be recalled to a job from which they had been laid off need not have been looking for work to be classified as unemployed." This is an important distinction, because you have to be specifically looking for work in order to qualify as unemployed. People that have been unemployed for so long that they simply stop searching for a job, drop out of the picture. They are no longer considered unemployed. This becomes increasingly likely as the length of unemployment becomes extended. Looking at those who have been unemployed for 27 weeks or longer as a percentage of total unemployed illustrates the potential for large numbers to simply give up looking. While this figure has declined from a high of over 45% in June of 2010, it is still very high by historical standards (see Chart below).
When unemployed persons cease to search for work, they are removed from the numerator, as well as from the denominator (civilian labor force) of the unemployment rate. This is important, because it can lead to a declining unemployment rate due to people dropping out of those considered unemployed rather than finding a job and becoming employed. Let's consider a simple economy that has only 15 persons in its civilian labor force. Times are tough and five of those people are unemployed, for a high unemployment rate of 33%. Discouraged by the lack of prospects, two of them decide to just simply quit looking, generating a revised figure of 23% (three unemployed persons out of a civilian labor force of 13). Unemployment has declined dramatically, but are more people working, is the economy stronger? No. Of course, if those two people were lucky enough to find actual jobs, unemployment would decline even further to 20% (three unemployed persons out of the same civilian labor force of 15). The second scenario is the one the Federal Reserve is hoping for, the first scenario is the one we are getting. How do we know? We can look at the labor force participation rate, that is the civilian labor force divided by the civilian non-institutional population (the sum of persons employed, unemployed and not in the labor force). Currently only 63% of those eligible for inclusion in the civilian labor force are actually participating in it. Obviously not all of those who are not participating are discouraged workers, but the big decline in participation rate since the onset of the Credit Crisis in 2008 is an indication that many of them likely are (see Chart below).
Another worrying sign can be found in the 'under-employment rate' as measured by U-6. U-6 adjusts U-3 (used above) by adding back 'marginally attached workers' (unemployed, looked for a job in the last 12 months, but not in the last four weeks), plus those employed part time for economic reasons that would like full time work. Both the numerator and denominator are adjusted to include these persons. As seen in the Chart below, this measure currently stands at 13.2%, still extremely elevated above historical levels. It is another indicator that the Federal Reserve's targets are being met, but without any real recovery to the state of the U.S. economy. Combined with the low level of inflation, the Federal Reserve's decision to curtail asset purchases may not make sense, given the sorry state of the underlying data.
One thing is certain, we appear to be a long way from the 6.5% target that the Federal Reserve reiterated would indicate the first possibility of short-term interest rate hikes from the near zero levels of today. They still view this level as reachable sometime in 2015, but in the past Chairman Bernanke has been careful to note that the 6.5% level is a threshold after which rate increases would be considered, not a trigger indicating an automatic rise. Going even further in the release this past Wednesday, the Committee noted that "it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6.5%, especially if projected inflation continues to run below the Committee's 2% longer-run goal". So even with the onset of tapering, we should not expect tightening any time soon. After our investigation beyond the headline numbers, it may even be too early for tapering.
* Shaded areas represent recessions
Source: Bureau of Labor Statistics