These Three Charts Illustrate the Fed's Labor Market Dilemma

For one thing, the historic relationship of labor market indicators such as the separation rate with wage growth appears to have broken down.

On Wednesday, the Bureau of Labor Statistics will release its latest Job Openings and Labor Turnover survey at what is a critical time for Federal Reserve policymakers.

Members of the Federal Open Markets Committee had been signaling their intention to hike the central bank's benchmark interest rate in September for the first time since June 2006. However, a combination of oil price falls and volatility in financial markets following China's decision to allow the yuan to weaken has left many people questioning the wisdom of the Fed moving this month.

On Aug. 26, New York Fed President William Dudley said that a September liftoff had become "less compelling" over recent weeks.

“From my perspective, at this moment, the decision to begin the normalization process at the September FOMC meeting seems less compelling to me than it was a few weeks ago,” Dudley told a news conference at the New York Fed.

“Normalization could become more compelling by the time of the meeting, as we get additional information on how the U.S. economy is performing and more information on international and financial market developments.”

Among the biggest problems facing the Fed are the confusing and often conflicting signals being given by the U.S. labor market.

According to the Fed's FRB/US model, the natural rate of unemployment or the non-accelerating inflation rate of unemployment (NAIRU) in the U.S., is assumed to be around 5 percent. That is the rate below which further falls in the unemployment rate would be expected to exert upward pressure on prices.

Yet, despite the unemployment rate having fallen to 5.1 percent, those inflationary pressures have been difficult to see in the data:

Bloomberg

Critics argue that consumer price inflation is a lagging indicator and that the Fed needs to raise rates from their current emergency levels in order not to fall too far behind the curve. They point to labor market indicators such as the separations rate and the quits rate that have seen sustained improvement over the past two years and have historically had a strong pro-cyclical correlation with wage growth.

Unfortunately, while the trajectory of the separation rate (which includes quits, layoffs, and discharges and other separations, including retirements) is consistent with a significant tightening of the labor market, the separation rate's historic relationship with wages appears to have broken down recently.

Splitting out quits, which a recent paper from the Chicago Fed argued has historically shown a remarkably strong relationship with wages, the recent break is just as marked:

George Magnus, a senior independent economic adviser to UBS Group, said he can see a number of possible reasons for the recent disconnect.

"The key issue is the non-responsiveness of income formation. Why isn't it responding yet?" said Magnus. "There could and are several reasons including: a) quit and separation rates are up but not yet up enough to make a big difference. Given time, this might correct; b) changes in minimum wage and other employer programs for the lowest paid have encouraged marginally better paid but non-beneficiary peer workers to leave but with average earnings still static. This reflects on behavioral changes that don't push up wages; and/or, c) the impact of digital tech on middle income paying occupations, i.e. compression of jobs and pay, which means higher income formation for better skilled/paid but greater competition for everyone else."

June paper by Federal Reserve economists Andrew Figura and David Ratner argued that the failure of inflation to pick up, despite the unemployment rate having dropped to the assumed natural rate, may reflect weaker labor bargaining power and a lower labor share of output. If so, the economy could be able to continue adding jobs without much upward pressure to prices.

With the data painting a confusing picture of labor market conditions, the FOMC faces the unenviable task of looking through the headline figures to assess what rate path is consistent with meeting its 2 percent inflation target over the medium term.

If there is significant slack left in the U.S. job market, it is likely to be in the labor force participation rate, which remains significantly below its pre-crisis level. As Fed Vice Chairman Stanley Fischer said at this year's central bank conference at Jackson Hole, Wyo.:

We are interested also in aspects of the labor market beyond the simple U-3 measure of unemployment, including, for example, the rates of unemployment of older workers and of those working part-time for economic reasons; we are interested also in the participation rate. And in the case of the inflation rate, we look beyond the rate of increase of PCE prices and define the concept of the core rate of inflation.

Complicating things still further, Bloomberg's Dan Moss noted that the August jobs report "tends to undershoot" and has historically been subject to significant revisions. This is likely to add to the long list of uncertainties facing FOMC members.

The confusion was evident in the minutes of the July meeting, where some participants expressed concern that inflation may remain below target over the forecast period, despite evidence that much of the remaining slack in the economy is being used up.

"Some participants expressed the view that the incoming information had not yet provided grounds for reasonable confidence that inflation would move back to 2 percent over the medium term and that the inflation outlook thus might not soon meet one of the conditions established by the Committee for initiating a firming of policy. Several of these participants cited evidence that the response of inflation to the elimination of resource slack might be attenuated and expressed concern about risks of further downward pressure on inflation from international developments."

The markets are still putting a roughly 30 percent chance that the Fed will move in September, but if the JOLTS survey undershoots expectations, they may yet elect to hold fire once again.

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