What’s in a (trend payrolls) number? The Chicago Fed paper that shook the markets, ever so slightly

June 13, 2013


Ann Saphir contributed to this post

The apparent conclusion from one of the most dovish regional Federal Reserve banks was rather surprising: The economy may actually need much smaller monthly job growth, of around 80,000 or less, in coming years in order for the jobless rate to keep moving lower. The immediate policy implication, it might seem, is that the U.S. central bank may have to tighten monetary policy much sooner than previously thought.

Andrew Brenner of National Alliance remarked that, while the report should be taken with a grain of salt, “this translates to lowering the bar to QE tapering.”

Right? Not necessarily, writes Goldman Sachs economist Jan Hatzius. Here’s why:

This estimate has raised questions whether the unemployment rate could fall faster than generally believed, and whether the first hike in the funds rate could therefore occur earlier than currently predicted.

But it is important to keep in mind that the Chicago Fed economists base their 80,000 estimate on the change in the trend participation rate. This is not a technical detail. If the actual participation rate is currently below trend but is likely to converge to trend over time, the pace of job growth will need to be materially above 80,000 per month to keep the unemployment rate stable, at least over the next few years.

Some background: Before the financial crisis, economists generally estimated it took around 150,000 new jobs a month to keep up with population growth. Anything in excess of that would help to bring down unemployment, according to that conventional wisdom.

However, the Chicago Fed paper, extrapolating historical rates of labor market participation into the future, find that number will gradually fall, primarily due to demographic changes in the labor force (like people retiring).

Hatzius explains in further detail:

Following this note, we have received a number of questions about the likely path of the unemployment rate and the implications for monetary policy under the current “threshold” guidance for the first hike in the federal funds rate. The reasoning is that if “trend” employment growth is just 80,000, then even historically moderate job gains of 200,000 per month would push down the unemployment rate by close to 1 percentage point per year. This implies that the FOMC would reach its current 6.5% unemployment threshold for the first hike in the federal funds rate by mid/late 2014…a significantly earlier hike in the funds rate than predicted by many economists; our own forecast for the first hike is currently 2016Q1. […]

But … there are good reasons to think that the actual labor force participation rate is currently far below trend; in fact, the Chicago Fed economists themselves show a gap of about 1½ percentage points in their Exhibit 1.A. If the gap between the actual and trend participation rate really is cyclical, we should expect it to close over time. In turn, this would imply that trend – or perhaps we should for clarity say “breakeven” – job growth over the next few years will be significantly higher than 80,000 per month.

In fact, the Chicago Fed economists make a similar point, but bury it near the end of the paper. “Average job gains of about 240,000, 195,000, or 165,000 per month over the next three, four, or five years would close the gap (between trend and actual payroll employment),” they write. Even with job growth at twice the 80,000 “trend” rate, in other words, it won’t be until the end of 2017 before unemployment falls to what they see as a more normal 5.25 percent.

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