by the Asset Allocation Committee | PDF

Last week, the federal government’s enhanced unemployment benefits of up to $300 per week expired nationwide. It has been speculated that the end of these benefits could lead to a surge of new entrants into the labor market. However, data from the Bureau of Labor Statistics (BLS) suggests this may not be true. In June and July, roughly half of the states in the country exited the program for enhanced unemployment benefits. Subsequently, the states that exited the program did see a sharper decline in the number of initial claims filed, but they had a slower increase in the number of workers entering the labor force. It should be noted that two months of data is not a long enough time period to draw any decisive conclusions about the labor market. That being said, if this trend continues, it may encourage the Federal Reserve to hasten its withdrawal of monetary stimulus.

The latest jobs report has led to speculation that the Fed could delay the withdrawal of its monetary stimulus. According to the BLS, the country added 235,000 jobs in August. This is less than a quarter of the jobs created in the previous month. The steep slowdown in job creation has led many to call into question the strength of the economic recovery. In anticipation of a possible delay in the withdrawal of monetary stimulus, investors sold off Treasuries and purchased tech stocks. On the day of the report, the NASDAQ closed at an all-time high, while the S&P dipped slightly.

Although the focus on employer payrolls makes sense, it may not be the most material data point when trying to gauge the Fed’s next policy move. St. Louis Fed President James Bullard has downplayed the importance of the payroll numbers in June, arguing that the labor market can still be tight even if payrolls remained below pre-pandemic levels. So far, the data supports this view. The latest JOLTS report showed that there are over two million more job openings than there are people looking for work. Over the last few months, firms have opted to raise wages in order to attract more workers.

The biggest drag on the labor force has come from workers on the extreme ends of the age spectrum. The youngest, excluding 16-19-year-olds, and oldest age cohorts have been reluctant to return to the labor force. Although higher wages may be enough to attract some younger workers, attracting older workers could prove to be more complicated. For these workers, there is no need to rush back into the workforce as they can transition into their Social Security retirement benefits once the pandemic benefits expire. If this happens, it could signal to the Fed that the labor market is too tight. As a result, the decision to wind down monetary stimulus may hinge on the willingness of older workers to reenter the workforce.

With enhanced unemployment benefits ending this month, the Fed will likely be paying closer attention to the labor force. In a recent interview, Bullard argued that the payroll data will likely be choppy from time to time but he expects the country to add 500,000 jobs per month this year. So far, the country is averaging 586,000 jobs per month. He also noted that he expects more people to reenter the labor force following the expiration of enhanced benefits. Given the comments he made in June, we suspect that he and possibly other policymakers may be more concerned with the number of people entering the labor force than the number of jobs created. In the event that workers do not return to the labor force, we expect there will be increased support for the Fed to escalate the pace of its stimulus drawdown. An early exit of its asset purchase program may give the Fed the ability to raise rates in a timelier manner. This outcome should increase interest rates, improving the outlook for shorter duration fixed income.

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by the Asset Allocation Committee | PDF

Chair Powell’s term as leader of the FOMC comes to an end in early February 2022.  It appears likely, at this time, that he will be reappointed for another four-year term.  Decision markets currently put the odds of another term at 85%.  Given all the policy actions that are on the docket for this autumn—an infrastructure bill, the budget, and the debt ceiling—not to mention the political capital lost over Afghanistan, it seems unlikely that the administration has enough bandwidth to push a new Fed chair through Congress.  The path of least resistance is to renominate Powell.

However, least resistance doesn’t mean no resistance.  Left-wing populists in Congress want a different Fed chair.  This group thinks Powell is too lenient on bank regulation and wants someone more committed to climate change policy.  Powell has mostly conducted an accommodative monetary policy.

This chart shows the real fed funds rate; Powell’s term is shown by the vertical line.  Although he briefly had a positive real policy rate in parts of 2018 and 2019, most of his tenure has seen negative real policy rates.  And, his quick reaction to the pandemic has been widely complimented.

Opponents to Powell’s reappointment are really getting at philosophical issues surrounding the central bank.  The question really is whether or not central banks should be independent.  There is a longstanding difference of position on central bank independence.  For those who oppose it, the argument is that the central bank should have monetary policy aligned with fiscal policy.  This is what is often called the “whole of government” approach.  It makes sense that policy should move in a single direction; it makes little sense for government policy to work at cross-purposes and that outcome is possible with an independent central bank.  During WWII, the Fed stabilized interest rates in order to support the war effort.  This is a classic whole of government policy.  It would have caused problems if the Fed had raised rates to offset the effects of government spending on the war effort.

It appears to us that Powell’s opponents are really pushing for a whole of government approach.  The argument seems to be that the issues of inequality and climate change are so critical that normal policy approaches are not justifiable.  Instead, the Fed should conduct monetary policy to support government efforts to transform the economy away from fossil fuels and to reduce inequality.  Therefore, fiscal spending to reduce the impact of climate change should be accommodated by expanding the balance sheet to provide affordable funding.

Those who argue for central bank independence point out that money is critical to the proper functioning of society.  There are essentially two ways that societies have tried to enforce monetary stability.  The first is through linking money creation to a commodity, often gold.  The idea is that users will have more faith in the store of value function of money if the control of the supply is given to an entity outside of government.  Since gold is created through mining, the supply of money is independent of government actions.

The second way that societies have created stable money is through central bank independence.  The idea is that if the central bank’s primary job is defending the value of the currency (which ultimately is about stabilizing inflation), and if it can act independently of fiscal policy, then stable money can be created.  For the most part, most nations have stopped using a metal standard for money; in practice, metallic standard money was too inflexible.  During periods of industrialization, when the supply of goods rose, the supply of gold might not expand fast enough to prevent deflation.  History shows that consumers and firms tend to act asymmetrically to deflation compared to inflation.  Deflation tends to depress consumption and investment because there is less incentive to spend as prices are declining; the longer one waits to buy, the better the price.  So, governments have concluded that moderate inflation is the best outcome for society.  Since the 1980s, there has been a consensus that central bank independence coupled with a clear inflation target was the best way to stabilize money.

Policy differences have tended to be constrained within the framework of central bank independence.  There have been debates between “hawks” and “doves” about how policy should be implemented.  In general, the hawks lean toward maintaining a low inflation target and moving preemptively to ensure the target isn’t violated, whereas doves tend to be more forgiving on violating the inflation target to support economic growth.  Recent actions, led by Chair Powell, to make the inflation target less stringent suggest he leans dovish on policy.

In general, the argument for the whole of government approach is that it makes little sense for government policy to work at cross-purposes.  If the economy needs stimulus, why should fiscal policy be eased while monetary policy is tightened?  The downside of this approach, as history indicates, is that every government believes its goals are sacrosanct and wants no constraints; this situation will tend to lead to higher inflation.  The monetary stability approach, in contrast, suggests that money is too important to be left solely in the hands of the political class.  Left to their own devices, the political class will tend to put less emphasis on monetary stability.  Thus, either a metallic standard or central bank independence is necessary.  Critics of this approach argue that policy can be overly constraining.

What the left-wing populists are proposing isn’t simply a dovish policy but a wholesale change in the conduct of monetary policy.  Selecting a different Fed chair probably won’t accomplish that outcome; the Federal Reserve-Treasury Accord of 1951 established the Fed’s independence.  It would likely take a broader act of Congress to accomplish what the left-wing populists want.

For investors, this debate is critically important.  Although Chair Powell will likely be renominated, the push for a whole of government approach is something that bears watching.  Modern Monetary Theory assumes a non-independent central bank and that theory has been in ascendency.  A move away from central bank independence increases the odds of higher inflation and less constraint on government policy.  Although the Fed remains independent, that policy isn’t scriptural; it comes from Congress and can be removed by that same body.

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by the Asset Allocation Committee | PDF

(Note: due to the upcoming Labor Day holiday, there will not be an accompanying podcast episode this week.)

With the first update of Q2 GDP, the Commerce Department released its corporate profits for the economy.  Using after-tax profits, which exclude inventory adjustment and depreciation, profits relative to GDP hit a new record.

By this measure, profits were 11.8% of GDP, edging out the previous peak of 11.7% in Q1 2012.  The data show that it is not unusual for profits to decline in recessions and rebound in recoveries.  However, this recession, though deep, was the shortest on record.  The profit/GDP recession trough was the highest in the postwar era; in other words, the usual profit decline, scaled to GDP, was much less than seen in earlier recessions.

S&P 500 operating earnings relative to GDP have hit a new record as well.

The key question is whether the surge in profits, both on the national level and for the S&P 500, can be sustained.  The history of both series suggests that, absent a recession, earnings tend to moderate but remain elevated.  So, optimism about future earnings is justified.  However, there is a broader issue at work.  In the 1970s, when inflation was elevated, corporate profits tended to rise in tandem with prices.  Firms, facing higher costs, were able to pass along these costs to their customers.  This action exacerbated inflation.  Until we see supply constraints ease, inflation will continue to rise unless consumers reduce their spending or profit margins fall.  If margins are maintained, either inflation will remain elevated or consumers will have to reduce their spending.

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by the Asset Allocation Committee | PDF

Since the Federal Reserve was granted independence in 1951 there have been 11 recessions.  Although each recession and recovery are somewhat unique, analysts tend to compare them for clues about future economic activity and policy actions.  In terms of monetary policy, Chair Powell has staked out a dovish path, suggesting that the first rate hike may not occur until 2023.  However, recent comments from Fed officials suggest the chair’s position is becoming increasingly isolated.

On this table, voters are designated by stars.  Currently, there are five committed doves on the FOMC.  We expect the no-bias camp to vote for stimulus reduction next year at the earliest.  The hawks, on the other hand, are committed to moving this year.  Although we could see a rise in dissents later this year, we suspect that policy will remain steady until 2022.

Next year could be interesting, to say the least.  Powell’s term as chair ends in February and Quarles’s term as vice chair for regulation ends in October 2021.  His full term as governor extends to 2032; although it is customary for a governor to step down once a vice chair position ends, Quarles has indicated he will stay around for a while.  If the no-bias group shifts to tightening, Powell may have to tighten or face losing a vote.

Monetary policy in recoveries and expansions has varied over the years.  Prior to 1982, it wasn’t always clear from the behavior of fed funds alone whether policy had changed.  To estimate changes, we can also use the New York FRB discount rate as an indicator.

Looking at the recessions from 1955 (the first after independence) onward, what is striking is that the FOMC often moved to raise rates rather quickly after the recession ended.  During the seven recessions, the average number of months from the end of the recession to the first rate hike is 13 months.  In the past three, the average is 48 months.  It has been four decades since the FOMC raised rates quickly into a recovery.  For three decades, investors have become accustomed to the slow withdrawal of stimulus.

However, this recovery appears to be much different than the past three.  In part, the recovery has been stronger due to massive fiscal and monetary policy support.  But another factor is that the recession, although short in duration, was unusually deep.  Although sometimes deep recessions have “L”-shaped recoveries, this one did not.  One way to see this is by comparing job openings to the number of unemployed workers.

During the entirety of the recovery from the 2001 recession, the number of unemployed exceeded job openings.  In the previous recovery, it took until March 2018, almost nine years after the recession ended, for openings to exceed the number of unemployed.  In the current recovery, we crossed that line in May, 13 months after the last recession ended.

Unfortunately, the JOLTS report, which measures job openings, started in 2000, so it doesn’t provide a long-term history.  The Conference Board had a series where it measured help wanted ads relative to the number of unemployed.  It was discontinued in 2010.  Although that number is a ratio based on an index, we created a model from the JOLTS report that approximates the help wanted/unemployed ratio to the present.

Comparing the behavior of the help wanted/unemployed ratio from the end of every recession since Fed independence, the current recovery is acting more like the pre-1990 cycles.  We have denoted the past three with dots on their lines and it is notable that the labor market didn’t improve over the two years after the end of the recessions.  So far, the FOMC leadership is acting as if this recovery is similar to the past three cycles; if it is not, policy will likely need to tighten much faster than the market expects.

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