Geld Zug: THE US NAIRU BASE IN MACRO-NESIA

Don’t economists just love acronyms? The usual suspects incorporate GDP and CPI, which everybody recognises – or should – instantly. Moving up the economists’ food chain, we can find other delectables such as PCE, RFR & ERP. Once you enter the realm of the macro economists, the populist pinnacle (because what this class of economists talk about actually sometimes is of relevance to the man on the street), we are blessed with exposure to a whole new universe. The one that currently appears in the media with increasing frequency, for very good reason so the Fed tells us, is one of my personal favourites, “NAIRU”.

 

Not to be phonetically confused with the island nation Republic of “Nauru” in Micronesia, NAIRU is located very much in the realms of macro policy. NAIRU, in English, is the non-accelerating inflation rate of unemployment. The FOMC (Federal Open Market Committee – sorry, this acronym is not technically the domain of economists) periodically releases projections or estimates (CY, CY+1, CY+2 years and a “long run”) of a number of metrics pertinent to their determination of monetary policy settings. These include GDP, the unemployment rate, PCE (personal consumption expenditure) inflation and Core PCE inflation measures. Given that the inflation rate has largely remained static in recent times (even reacting only mildly to the materially significant deterioration in energy prices of ~55% in the last 12 months), the Fed is increasingly focussed on the speed of the rate of change of the unemployment rate.

 

NAIRU is effectively therefore often viewed as a direct representation of the FOMC’s view of its own estimates of the unemployment rate being consistent with “full employment”. The “high” band of the FOMC’s central tendency projections is approximately 5.2%. Headline unemployment is currently 5.3%. The “low” band of the FOMC’s central tendency forecasts is approximately 5.0%.

 

Where NAIRU sits is of importance given that we know that monetary policy often will, empirically, direct inflation and unemployment in opposing ways. Given that the overnight Fed Funds rate (monetary policy) has been at the zero bound now for years and that the Fed is internally debating whether to raise interest rates either this year or the next for the first time since 2004, the efficacy of monetary policy has never before in history been so studiously observed.

 

The Federal Reserve’s dual mandate causes them to pay incredible heed to where levels of inflation and unemployment are. The economic theory attempts to draw a link between the short term effects of monetary policy being that inflation and unemployment are pushed in opposite directions. Other schools of economics believe that NAIRU is also affected by changes in productivity, not just inflation and unemployment. As far back as 1752 in economic literature, linkages were formed between the supply of money upon inflation & unemployment. The Fed is today, in 2015, attempting to ascertain where NAIRU should sit, given the impact that their abnormal policy settings since the GFC have had on the two variables that they say determines, more than anything else, whether or not they raise rates.

 

The Fed has been understandably surprised that keeping rates at an effective overnight rate of approximately 0.14% since the GFC and then additionally increasing the circulation of non-gold-backed currency has not contributed more to inflation. Indeed, QE was introduced to attempt to revive some semblance of inflationary expectations into the economy by attempting to influence the long end of the yield curve. That is to say, to attempt to increase 10 year bond yields. Core Personal Consumption Expenditure Inflation in the US for 2015 remains in the 1.3 - 1.4% range. This only “improves” towards where the Fed would like it to sit, by 2016, in the 1.6 – 1.9% range. Only by 2017 do the FOMC members believe that core inflation (which does not take into account the volatility that energy and food price fluctuations introduce to the inflation basket) will begin to approach the desired 2.0% level.

 

The employment data in some regard contributes an even murkier sense of how to dictate monetary policy than the inflation rate, which has not reacted as many market participants initially suspected – remember gold at USD$1800 just a mere few years ago? The vacuum of demand for physical gold now that inflation doesn’t appear to have panned out to be a global problem, is these days filled almost solely by Indian jewellers and former Chinese equities market investors. Employment has been steadily increasing since the nadir of the GFC, however it has only been in the past 12 months that the nominal number of people employed in the US workforce has returned to the previous high of employment levels pre-GFC. Additionally worrying is that the participation rate in the US labor market is now on par with levels last seen in the 1970s. However, even from 2016, the FOMC members expect that headline unemployment will range from 4.9% to 5.1%.

 

The notion that the Fed presents to us is that by next year (2016) unemployment (headline, and not taking into account participation rates) will have recovered to be in fact below the NAIRU rate, whilst inflation will still not have returned to the Fed’s targeted long run rate of 2.0%. The expected trajectory of inflationary expectations gives weight to the doves at the Fed who do not favour an early rate rise. However, the Fed’s own central tendency forecasts (taken from all 17 Governors of the Federal Reserve system) indicate that by the end of calendar 2016, US interest rates will be approximately 1.5%.

 

15 out of those 17 Governors believe that the appropriate time for monetary policy to be “firmed” (as the Fed words it) is calendar 2015. Only 2 of the 17 dissent, and believe that said “firming” should not take place until 2016.

 

How does this affect the outlook of the US economy and US capital markets given that the Fed demonstrably expects and estimates that NAIRU will be between 4.9% and 5.1% next year? The Fed patently thinks that if they raise interest rates this year, 2015, then that will contribute ever-so-slightly to improving inflationary expectations, yet will actually drive the unemployment rate lower? Our view from NAIRU is that the 2 dissenting Governors may well be correct in their wish to allow further productivity gains associated with current extraordinarily low base rates persist for a few more quarters yet.

 

Given the amount of global dislocation evidenced by the taper tantrum event in 2013 when Bernanke’s words were misinterpreted by the market that QE was going to be concluded earlier than the market had previously expected, we shudder to think what one short sharp rate rise will do to US debt markets, emerging market economies with material USD bonds outstanding and then of course the US equities market. As we know, the US has one of the most liquid labor markets in the world. When distress affects the real economy (transmitted in most cases via the financial markets, notably the GFC in recent times) the US is able to shed jobs at a rapid pace to offset “business risk”. The converse of this is that US companies (as evidenced by the upturn out of the GFC) can also re-hire those previously fired employees, very quickly.

 

We would like to see the headline unemployment rate go some distance between the mid point and the low range of NAIRU before Dr Janet Yellen at the Federal Reserve raises rates. This may occur naturally some time in early to mid 2016, but is unlikely to occur by September 2015. So, delay a little longer, dear Chairman. If the Fed does raise rates, then the outcome to debt markets, equity markets and the real economy is not quantifiable. It is not quantifiable because the US has never had to raise rates from zero to “something” ever before in history. When it inevitably does this (hopefully once unemployment is 5.0% or lower) then it would be comforting to know that investors’ funds are held within hedge funds that are capable of providing downside protection. The Fed will not raise rates until it thinks the real economy can sustain a rate rise, but the manner in which the Fed removes the band-aid will still cause the 7-years-now suffering US patient some degree of discomfort.

Sources:

Ball, Laurence. Professor of Economics, John Hopkins University

The Financial Times

Mankiw, N. Gregory. Professor of Economics, Harvard University

FRED Database from the Federal Reserve Bank of St Louis

The US Federal Reserve

 

Marcel von Pfyffer

Q.E.D.

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