Economic Monitor – Weekly Commentary
by Scott J. Brown, Ph.D.

Deflation, low inflation, and monetary policy
January 19 – January 23

Central bank policymakers fear deflation more than anything. However, there is good deflation and there is bad deflation. Yet, even low inflation can create problems for an economy. Low inflation is expected to be a key factor in the ECB’s decision to embark on quantitative easing and ought to have some influence on the timing of the Fed’s initial rate hike.

Deflation, a negative inflation rate or a general decline in the overall price level, is a scary prospect for monetary policymakers. Consumers will have little incentive to spend, as prices will be expected to fall the next month. Business will have little incentive to make capital expenditures, since they are less likely to realize a return on that investment. Debt becomes much more burdensome, as borrowers end up paying off the debt with dollars that are worth more. Yet, Japan’s experience with deflation is that it need not be the death spiral that theory would suggest. During Ben Bernanke’s tenure, first as Fed governor, then as chairman, the Fed went from “making sure it doesn’t happen here” to being relatively complacent.

There are different types of deflation. Lower prices that are due to rapid productivity growth or falling commodity prices are nothing to fear (for example, falling gasoline prices make it easier to service debt). Deflation caused by weak demand is what we fear. It is due to slack in the economy and represents an underutilization of resources.

There’s nothing magical about 0% inflation. Extended periods of low inflation can also cause problems. In the first half of 2014, The Federal Open Market Committee noted in its policy statements that “the Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.”

The Fed’s concern about low inflation seemed to disappear in the second half of 2014, as this phrase did not show up in the policy statement. That partly reflects confidence that economic slack is being taken up and the belief that inflation will eventually move toward the Fed’s 2% goal. That outlook is largely based on the trajectory of the job market. On balance, the labor market data indicate improved momentum. In 2014, private-sector payrolls posted their largest gain since 1997, supported by hiring by small and medium-sized firms. Bank credit for these firms is still relatively tight, but has been gradually getting easier and optimism is on the rise. However, many labor market indicators, including lackluster growth in average hourly earnings, suggest that there is still ample slack.

The U.S. picture is a contrast to that of the euro area, which appears to face a more immediate threat of deflation, but as previously noted, even low inflation can create problems. With short-term interest rates at zero, quantitative easing is the only game in town for the ECB. This isn’t an easy decision. Some members of the Governing Council will be strongly opposed. However, the risks of not doing QE are greater. QE should put more downward pressure on the euro, which will help exporters, but it should also boost inflation somewhat.

For the Federal Reserve, lower oil prices are a blessing. It’s not the type of deflation that officials should worry about. It ought to support economic growth, which will eventually lead to a tightening up of resources. It gets back to the same old questions. How much slack is there in the labor market? How rapidly is that slack likely to be taken up in the months ahead? And will firms be able to pass higher labor costs along (in the form of higher prices)? None of this is currently clear, but the Fed has time to be patient and watch things develop. Officials have noted that they are watching financial market conditions. Unsettled conditions could keep the Fed on hold for a lot longer, but we ought to see market volatility begin to settle down.


The Job Market and the Fed
January 12 – January 16

The December Employment Report presented a mixed job market picture. The establishment survey data reflected strong job growth, but with a lackluster trend in average hourly earnings. The household survey showed a larger-than-expected drop in the unemployment rate, but that was due to a decline in labor force participation. What should Fed policymakers make of this report? Patience, grasshopper, patience ...

Next month, the Bureau of Labor Statistics will release annual benchmark revisions to the payroll survey data. That’s unlikely to alter the recent picture. In September, the BLS indicated that it expects that (based on payroll tax receipts) the March 2014 estimate of payrolls will be lifted by a mere 7,000 (or less than 0.05%). The BLS will also add two lines to the payroll table, the three-month average monthly gains for total and private-sector payrolls. This isn’t a hard calculation. Rather, the BLS will be emphasizing the trend in payroll growth over the monthly change. That’s a good thing. Investors pay way too much attention to the monthly figure, which is noisy and subject to revision. Payrolls averaged a 246,000 monthly gain in 4Q14. The average for private-sector payrolls was +238.000. This is over twice the rate of growth of the working-age population.

Nonfarm payrolls rose by 2.952 million in 2014, the strongest year since 1999. Private-sector payrolls rose by 2.861 million, the best since 1997. The ADP payroll estimate suggests that job gains are being led by small firms, with good strength in medium-size hiring as well. This is what one should naturally expect to see as the economy gathers steam.

The household survey data painted a somewhat different picture. The unemployment rate fell to 5.6% (a level which was once considered to reflect “full employment”). However, the decline was due to a drop in labor force participation. The employment/population ratio, the preferred measure of labor utilization, held steady – up just 0.4 percentage point from a year ago. That suggests that while labor market slack is being taken up, the improvement is very gradual. Progress is more apparent for the key age cohort (those aged 25 to 54), but the ratio remains well below the pre-recession level (which was well short of the peak in the late 1990s).

A month ago, average hourly earnings were reported to have risen 0.4% in November, which led some to declare that more rapid wage growth had finally arrived. Whoops. Average hourly earnings fell 0.2% in December, while the November figure was revised down to +0.2%. Luckily, a drop in the Consumer Price Index will boost real earnings for December. However, the lackluster growth in hourly earnings is one more sign of slack.

Minutes of the December 16-17 Fed policy meeting noted that officials could begin raising short-term interest rates even if inflation remains low (as long as it’s expected to move to the Fed’s 2% goal) and policy will remain very accommodative for a long time after the initial rate hike. At some point, the Fed will simply have to take its foot of the gas. Nevertheless, the risks surrounding the timing of tightening aren’t symmetric.


The Job Market and the Fed
January 12 – January 16

The December Employment Report presented a mixed job market picture. The establishment survey data reflected strong job growth, but with a lackluster trend in average hourly earnings. The household survey showed a larger-than-expected drop in the unemployment rate, but that was due to a decline in labor force participation. What should Fed policymakers make of this report? Patience, grasshopper, patience ...

Next month, the Bureau of Labor Statistics will release annual benchmark revisions to the payroll survey data. That’s unlikely to alter the recent picture. In September, the BLS indicated that it expects that (based on payroll tax receipts) the March 2014 estimate of payrolls will be lifted by a mere 7,000 (or less than 0.05%). The BLS will also add two lines to the payroll table, the three-month average monthly gains for total and private-sector payrolls. This isn’t a hard calculation. Rather, the BLS will be emphasizing the trend in payroll growth over the monthly change. That’s a good thing. Investors pay way too much attention to the monthly figure, which is noisy and subject to revision. Payrolls averaged a 246,000 monthly gain in 4Q14. The average for private-sector payrolls was +238.000. This is over twice the rate of growth of the working-age population.

Nonfarm payrolls rose by 2.952 million in 2014, the strongest year since 1999. Private-sector payrolls rose by 2.861 million, the best since 1997. The ADP payroll estimate suggests that job gains are being led by small firms, with good strength in medium-size hiring as well. This is what one should naturally expect to see as the economy gathers steam.

The household survey data painted a somewhat different picture. The unemployment rate fell to 5.6% (a level which was once considered to reflect “full employment”). However, the decline was due to a drop in labor force participation. The employment/population ratio, the preferred measure of labor utilization, held steady – up just 0.4 percentage point from a year ago. That suggests that while labor market slack is being taken up, the improvement is very gradual. Progress is more apparent for the key age cohort (those aged 25 to 54), but the ratio remains well below the pre-recession level (which was well short of the peak in the late 1990s).

A month ago, average hourly earnings were reported to have risen 0.4% in November, which led some to declare that more rapid wage growth had finally arrived. Whoops. Average hourly earnings fell 0.2% in December, while the November figure was revised down to +0.2%. Luckily, a drop in the Consumer Price Index will boost real earnings for December. However, the lackluster growth in hourly earnings is one more sign of slack.

Minutes of the December 16-17 Fed policy meeting noted that officials could begin raising short-term interest rates even if inflation remains low (as long as it’s expected to move to the Fed’s 2% goal) and policy will remain very accommodative for a long time after the initial rate hike. At some point, the Fed will simply have to take its foot of the gas. Nevertheless, the risks surrounding the timing of tightening aren’t symmetric.


The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.

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