Full Unemployment, Understated Wage Growth, and the Pace of Normalization

Let me start by saying that inflation has a much bigger demographic component than monetarists and mainstream economists acknowledge – it’s no coincidence that the 1970’s inflation occurred when Baby Boomers were forming households – and that a 2% inflation target will be seen to be wildly inappropriate for the prime Millennial household formation years. From 1968-1987 there were over 32 million housing starts in the US, or over 1.6 million a year, and that’s before the Boomer trade up/McMansion years. The inflation target will have to be raised, and should be raised – in the 2020’s 2% inflation will probably be consistent with 7% unemployment – but we’ll have to suffer through a recession first. That being said, the Fed believes in its 2% inflation target and my job is to figure out what they are likely to do, not what they should do.

If you’re in the business of 2% inflation and managing market volatility you have to start removing policy accommodation in June. In addition to asking, “When can we expect sustained inflation?” the Fed must ask, “What does normal monetary policy look like, and in an aggressive case how long would it take to get there?”

We know from the Fed’s quarterly dot plots that they see the normal Fed Funds rate at 3.5-4%. And while nobody knows what the final size of the Fed’s balance sheet will be, Vice Chair Fischer recently said a final size could be something like $1-2 trillion.

So to keep this simple, let’s say that full policy normalization, setting aside cyclically tight policy, will require something like 3.5% worth of rate hikes and $2 trillion in balance sheet runoff/reduction. If the Fed began in June, how long would it take to get there?

There are 8 FOMC meetings a year. While I think we’ll eventually get rate hikes larger than 25bps a meeting, nobody on the Fed is going to say that explicitly right now. 25bps a meeting would take 14 meetings to get to 3.5-4%, or 21 months. Then there’s the balance sheet. If you rule out asset sales, as the Fed mostly has at this point, you’re somewhat restricted in the pace of runoff. It looks like roughly $400 billion/year is the fastest they could shrink the balance sheet. And that leaves out the lagged impact of monetary policy changes, estimated at 1-2 years.

So starting in June, you could get Fed Funds back to normal levels and shrink the balance sheet by $1 trillion over a 4-year period, which would still leave further balance sheet reduction required to get back to normal, and doesn’t account for getting to actual tight policy or the 1-2 year lag between policy changes and the impact in the real economy. Barring a much more aggressive policy tightening path, or Team Stagnation being right about things (they’re not), we’re looking at policy easier than we had at the peak of the last cycle through at least 2019 or 2020. And unlike in 2005-07, inflationary demographic tailwinds from Millennial household formation will continue to grow. June is going to be fine.

Turning to the employment picture, it’s not just that conditions continue to improve, but they’re improving at an accelerating rate. San Francisco Fed President Williams likes to use the analogy of a driver approaching a stoplight. If above-trend inflation represents the stoplight, we’re now pushing harder on the gas as we get closer to the light. This chart from Deutsche Bank shows that U6 is falling at a faster rate now than it was earlier in the recovery.

U6 is the last refuge of doves, and even that in early 2016 will be at 2004-type levels consistent with rate hikes in the last cycle.

Aggregate weekly payrolls has become one of my favorite employment measures because it accounts for number of workers, hours worked, and wage growth, and in construction, it continues to accelerate and is now at growth rates last seen in August, 2006. This is especially significant because construction is the one private sector that continues to lag in this expansion.

But you don’t need to get too detailed when plain old job growth is at 15-year highs.

Perhaps the most perplexing comments of all are from those who say “there are still no signs of wage growth.” Demographics have played a big part in this cycle, first by lowering the participation rate more than expected as Baby Boomers retired, which in turn lowered the unemployment rate faster than many expected. Now, demographics are working to have aggregate measures of wage growth appear lower than they really are.

This is a chart of age 55+ employment growth relative to overall employment growth. It increased in the late ‘90s as Baby Boomers started turning 55, was high in the middle of the last cycle (overstating wage growth), and now it’s about to fall below zero as the Baby Boomer retirement drag increases and younger, lower-paid workers replace them.

The flipside shows up in younger cohorts. In the 1990’s and early-mid 2000’s when Gen-X'ers were the age 25-34 younger-paid cohort in the workforce, age 25-34 employment grew slower than overall employment. Now it’s growing faster than overall employment, and will continue to do so for the next decade.

But perhaps my favorite chart is age 16-19 employment growth relative to overall employment growth. In case you’ve forgotten from your own teenage years (I spent one miserable summer as a bagger/cashier at Stop & Shop making $5.35/hr), teenagers are inconsistent, low productivity, low-paid workers. And yet teenaged employment growth is surging at rates unseen in decades. Not only does this signal a desperation on the part of employers, but it also serves to depress aggregate measures of wage growth. There’s a reason Walmart and TJ Maxx raised their minimum wage.

Perhaps the most elegant way to show this age effect is looking at lower-paid age 16-34 employment vs higher-paid age 35+ employment. From 1980-2010, age 35+ employment trounced the younger cohort. That has now stopped. We need measures of wage growth to be demographically-adjusted in addition to seasonally-adjusted. The age factor is real, to say nothing of possible ethnic biases with Hispanic and African-American workers replacing retiring white workers.

To sum up: the first and second derivatives of employment continue to grow, full employment is 6-12 months away, measures of wage growth are understated due to the changing age composition of the workforce, and the Fed must begin policy normalization sooner than some would like to keep the process somewhat smooth, as due to the lagged nature of policy changes we’re likely to have easy policy for the rest of the decade. The real risk is the Fed blocking the household formation of the largest generation in American history because of some stupid 2% inflation target that some economist who probably believes in NAIRU came up with.