The annualized trend of the last six months of inflation in the Core PCE or Core CPI is a very low 1.0%, inflation expectations for the next year are 1.2% and yet, the Fed continues to act hawkishly, professing hopes to further tighten policy this year and next.
Specifically, projections from the FOMC’s meeting yesterday showed that 11 of 16 members saw another rate hike yet this year and 11 of 16 members saw 3 or more hikes in 2018. Combined, a majority of the FOMC thinks that the Fed Funds rate will be above 2.125% by the end of 2018. Contrast that with market expectations. Just two weeks ago, the Fed Funds futures market thought that the rate at the end of 2018 would be 1.4%, and now, after the news from the Fed, 1.6%; still a wide gulf between the two.
To address this hawkishness, Janet Yellen repeated a prepared defense a few times yesterday in her press conference. Paraphrasing, she said that sub-2% inflation has made sense up until this year because the unemployment rate was high, but as of this year, with the unemployment rate below 5% (considered to be full employment), the Philips curve suggests that inflation should return. Therefore, the low inflation of 2017 must be temporary, transitory, or idiosyncratic (choose your favorite word to be dismissive), which then allows the FOMC to continue tightening policy.
This seems like a lot of reaching to justify further rate hikes. Where Ms. Yellen sees a conundrum in low inflation, we see a pretty simple forgotten concept; the recession caused a tremendous drop in the labor force participation rate and the unemployment rate is falsely low because of it. Put plainly, we are not yet at full employment.
If you take the pre-recession labor force participation rate and apply it today, the unemployment rate would be 9.0%! Now, there is a lot of argument as to whether retirees have structurally depressed the labor force participation rate but the evidence is dubious. In an article from April of last year from the Center for Economic and Policy Research, they say,
“The drop in LFPR [Labor Force Participation Rate] in the recession and weak recovery has been primarily a story of workers in their prime working years leaving the labor force, not baby boomers retiring or young people staying in school longer.”
In our view, this is why, from a Phillips curve perspective, that inflation continues to be weak, and has every reason to continue falling. The Taylor rule with a 9% unemployment rate would suggest a sharply negative Fed Funds Rate. Tightening into falling inflation seems like the wrong direction, we think the Fed is on the verge of repeating 1936.
More on the falling labor participation rate:
Forbes, “US Unemployment: Retirees are not the Labor Market Exodus Problem”
Economic Populist Blog, “Record Low Labor Participation Rate Not Due to Retirement or School“