Should an 'Improving' Job Market Restrain the Fed?

One of the economists who dissented this week says that the conditions aren't right for more stimulus. Is he right?

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On Tuesday when the Federal Reserve's monetary policy statement was released, something surprising occurred -- something besides the big news that it decided to tweak its language. Three committee members dissented with that change. We haven't seen this many dissenters since 1992. One of those committee members who disagreed with the majority's decision to state that rates would be left near zero through mid-2013 was Minneapolis Federal Reserve Bank President Narayana Kocherlakota. On Friday, he released a statement explaining his rationale.

His reasoning boils down to the following:

I dissented from this change in language because the evolution of macroeconomic data did not reflect a need to make monetary policy more accommodative than in November 2010. In particular, personal consumption expenditure (PCE) inflation rose notably in the first half of 2011, whether or not one includes food and energy. At the same time, while unemployment does remain disturbingly high, it has fallen since November. I can summarize my reasoning as follows. I believe that in November, the Committee judiciously chose a level of accommodation that was well calibrated for the prevailing economic conditions. Since November, inflation has risen and unemployment has fallen. I do not believe that providing more accommodation--easing monetary policy--is the appropriate response to these changes in the economy.

Going forward, my votes on monetary policy will continue to be based on the evolution of the data on PCE inflation and its components, medium-term PCE inflation expectations, and unemployment.

This is actually pretty straightforward. He's saying that we're seeing unemployment fall, so the labor market is moving in the right direction. Additionally, prices are rising at a moderate pace. As a result, the Fed's dual mandate doesn't require additional support. Let's consider each of these claims.

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Jobs Are Growing?

First, is the labor market really improving? Let's consider the official unemployment statistics since January, since 2010 already seems like a long time ago and an annual revision makes it hard to compare 2011 and 2010 data. That gives us six months worth of numbers.

First, the number of employed Americans has fallen since January by 27,000. In other words, there were fewer people working in July than there were in January. Moreover, the number of unemployed Americans has increased by 68,000 over this period. That's right: there were more unemployed people in July than in January. And as though that's not bad enough, the labor market participation rate has declined to 63.9% in July from 64.2% in January. If go back to November, the labor market participation rate was even higher -- 64.5%.

So we can conclude that in 2011, the labor market has not improved; it's worsened. Much of the improvement that we've seen since November has been in the form of Americans exiting the labor force. While it might be nice to imagine that the shrinking workforce can be blamed on retirees and isn't something to be alarmed about, that's simply false. Most of those Americans leaving the labor force want jobs but have temporarily given up looking.

Has Core Inflation Risen?

Meanwhile, we all know that inflation has jumped, in large part to energy prices. They jumped last spring, though they have been relaxing recently. If you take out food and energy to look at core inflation, then you still see higher inflation in the first six months of 2011 than in the last six months of 2010. Over these periods, core PCE prices increased by 1.0% and 0.3%, respectively.

(As a quick note, it's interesting to see Kocherlakota referring to PCE prices instead of the Consumer Price Index. Just yesterday, I explained how these two measures differ.)

So inflation is definitely up significantly in the first half of this year compared to the second half of last year. From this perspective, the Fed definitely doesn't need to provide additional monetary stimulus. There is no longer any reason to fear deflation.

The Final Verdict

Ultimately, Kocherlakota appears to be an inflation hawk who either isn't concerned with the very real unemployment problem or is misinterpreting the data. It's true that the unemployment rate is 9.1% now, which looks better than November's 9.8% rate -- unless you look closer. If the labor participation rate had remained at its November level through July, but those additional Americans who left the workforce were now considered unemployed, then the unemployment rate in July would have been 9.9% -- higher than November's 9.8%.

This Fed group might have a hawkish bent, given its three dissenters. For that reason, we shouldn't expect to see any monetary stimulus unless either inflation falls significantly or unemployment begins to rise so dramatically that not even inflation hawks can ignore it.

Image Credit: REUTERS/Jason Reed