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Weekly Commentary by Dr. Scott Brown

Yellen’s Three Big Questions (and a Few Others)
April 21 – May 2

Speaking to the Economic Club of New York, Fed Chair Janet Yellen presented an analysis of the monetary policy actions taken to address the Great Recession and offered guidance on what will drive policy decisions going forward. The centerpiece of her talk was about the three big questions that the Fed has to answer. However, there are a number of other debates going on in economics right now that have long-term consequences.

The Fed’s first big question is how much slack remains in the labor market. Yellen has spoken at length about the job market. Indeed, her dashboard is full of gauges suggesting that we are a long way from full employment. The unemployment rate has fallen, but the decline overstates the improvement in the job market. Part of the decline in labor force participation is demographics (the aging of the population), but most is due to discouraged workers who have given up on finding a job (hence, are not officially counted as “unemployed”) or other individuals who would take a good job if offered. The Business Employment Dynamics data (3Q13 data are due on April 29) suggest that labor turnover has been remarkably low in recent years. Job destruction is trending low, but fewer workers are quitting to pursue more attractive wage offers elsewhere.

The Fed’s second big question is whether inflation is returning to its 2% goal. Some observers are still screaming that, even though it hasn’t show up yet, hyperinflation is just around the corner. Hogwash! Inflation is a monetary phenomenon, but it shows up through pressures in resource markets. The soft global economy means limited upward pressure on commodity prices. U.S. imports (raw materials and finished goods) have exhibited modest price increases over the last year. With plenty of excess capacity, we aren’t going to see bottleneck or production pressures pushing prices of goods significantly higher. The labor market is the widest channel for inflation pressures, but we’re still seeing limited compensation gains.

The Fed expects inflation to trend back toward the 2% goal, but a prolonged period of low inflation creates some risks for the economy. All else equal, a continued low trend in inflation would push out the expected timing of a Fed rate increase.

The third big question is what could derail the economic expansion. Obviously, we don’t know. Yellen cited examples from recent years (the greater-than-expected fiscal tightening and spillover effects from Europe’s crisis). Yellen noted that the Fed responded to unexpected weakness in the U.S. economy with aggressive policy actions (QE2, Operation Twist, and QE3).

Yellen said that because the course of the economy is uncertain, the Fed needs to “watch carefully for signs that it is diverging from the baseline outlook and then respond in a systematic way.” That doesn’t mean responding to short-term wiggles, such as adverse weather. Rather, policymakers will respond to more substantial changes in the outlook.

Economists, mostly outside the Fed, are currently debating the longer-term prospects for the U.S. economy. One issue is the possibility of secular stagnation (a concern worldwide, not just for the U.S.). Barring an acceleration in labor productivity, a slowdown in labor input (as the population ages) implies a slower trend in GDP growth. Real GDP has averaged a 3% annual rate over the last several decades, but dipped below the trend line in the Great Recession and appears unlikely to return to that long-term trend in the foreseeable future. Continued subpar economic growth will reduce potential GDP growth.

Another concern is declining real wages for the bottom 90%. Adjusted for inflation, median weekly earnings for full-time and salary workers were the same in 1Q14 as they were in 1Q05. Low wage increases will make it harder for households to service mortgage debt and student debt (which has tripled over the last 10 years). A declining middle class (and deterioration in the lower part of the upper-income cohort) should be an important concern for all Americans, especially investors.


An Uncomfortable Discussion
April 14 – April 18

Income inequality is a touchy subject. It’s hard to have a polite conversation, but like it or not, we are going to have a discussion this year. I will not take a position here (this is largely a political question). Rather, I will try to illustrate what the data say and to present the different points of view.

In the fall of 2013, Thomas Piketty, a French economist, published a book titled “Capital in the 20th Century.” The English translation arrived in March. It’s been suggested by those on the left that the book may be the most important economic book of the year, if not the decade (just as Marx’s “Das Kapital” was in the 19th century). Piketty is not some lunatic radical. He is a well-respected scholar and has spent a considerable amount of time assembling an historical database of the distribution of income for several countries. The key point of the data is that there has been a sharp rise in income inequality over the last three decades and the distribution is increasingly more skewed the higher you go up the income scale. In the U.S., the top 10% of income earners account for 50% of national income. The top 1% account for 45% of the top 10%, the top 0.1% account for about half of the 1%, and the top 0.01% account for half of the 0.1%. Income inequality has risen in most advanced economies and is currently at or near record highs.

One of the key ideas in Piketty’s book is that if the rate of return on capital, r, is greater than the growth rate of the economy, g, then capital ownership will become increasingly more concentrated. He suggests that this has been the case throughout history, with the exception of the last 100 years. Piketty notes that this is not a market failure – it is the fundamental nature of capitalism. This turns one long-standing view in economics on its head. Starting from the 1950s and 1960s, it had generally been believed that economic prosperity benefits everyone across the income scale.

The question is whether rising income inequality is bad for economic growth overall, and if so, what can be done about it. Research by the IMF suggests that countries with higher income inequality tend to have slower economic growth. Piketty proposes that rising income inequality can be addressed through higher tax rates, not just in the U.S., but worldwide (otherwise investors would simply move to countries with lower taxes). This is where conservatives are going to draw the line. The right has long argued that low taxes encourage business investment. Raising taxes would reduce incentives. The left argues that tax rates have been a lot higher than they are now and the economy prospered just fine. Regardless, given the current composition of Congress, it would be extremely difficult to raise taxes and it would be virtually impossible to do so on a coordinated basis across countries.

It’s worth noting that the recession has added to income inequality. As Fed Chair Yellen has indicated, the lower trend in labor compensation suggests that there is a large amount of slack in the labor market. A tighter labor market would lead to faster growth in wages, which would help support faster growth in spending, and stronger growth would then lead to more jobs, etc. However, we still seem to be far from that point.

In the U.S., there is currently an active debate about whether to raise the federal minimum wage. While a higher minimum wage will have an impact on labor-intensive firms (restaurants, for example), it’s unlikely to have a significant effect on overall employment. Many states have minimum wages that are higher than the federal and studies show that there is relatively little impact on employment when the minimum wage rises. On the other hand, those on the left who argue that raising the minimum wage will reduce poverty will be disappointed – the research suggests that a higher minimum wage has little impact.

This week, Thomas Piketty will be in Washington and the income inequality discussion is expected to pick up.


The March Employment Report
April 7 – April 11

Last week began with a speech by Janet Yellen. The Fed Chair was not expected to say much of consequence, but instead, she continued to emphasize the large amount of slack in the labor market and the Fed’s strong commitment to reduce it. The clear implication is that short-term interest rates are not going up anytime soon. This message may have been meant to counter misconceptions taken away from her recent press conference. The March Employment Report remained consistent with the view that the labor market is improving, but we still have a very long way to go before we get back to normal conditions.

Private-sector payrolls have finally surpassed their previous peak, set just before the economy entered the Great Recession. That’s good news, but we would have expected to have added more than seven million new jobs over the last six years if not for the recession. Getting back to even isn’t enough. We’ve also lost more than 700,000 government jobs over this period (mostly in state and local government, but federal payrolls are 68,000 lower than when Obama took office). Nonfarm payrolls rose 1.7% over the 12 months ending in March, vs. growth in the working-age population of about 1.0%. Construction rose 2.6% (residential construction rose 7.9%). Manufacturing rose 0.6%, not much of a “renaissance.” Employment in wholesale and retail trade rose 2.1%. Finance rose 0.7%. Temp-help jumped 9.6%, which bodes well for future permanent job gains. Leisure and hospitality rose 2.9%. Healthcare rose 1.4%. Government fell 0.1% (federal -3.0%, state and local +0.3%).

The unemployment rate held steady at 6.7% in March, but was held up by an increase in labor force participation. Don’t read too much into that. It could simply reflect a rebound from poor weather. Seasonal adjustment is different across age groups and that can amplify weather effects (unemployment rates were lower in March for teenagers and those aged 25-54), but higher for young adults and the elderly).

The data for the key labor cohort, those aged 25-54 years, has shown a steeper rise in the employment/population ratio over the last several months. That’s good news, and improvement may broaden out to other sectors over the next several months. However, it still suggests a very large amount of slack in the job market. In turn, that slack is limiting upward pressure on wages and salaries, which means less fuel for consumer spending growth. This should eventually take care of itself. That is, wage growth will pick up as the labor market improves, but we have a long way to go. Consumer spending accounts for 70% of the GDP, which means that the pace of the economic recovery will be slower (than if wages were rising 3% to 4% year-over-year, vs. the current pace of around 2%).

Note that some of the “improvement” in the March data merely reflects a rebound from poor weather. However, an extended period of bad weather can have a longer-lasting impact on the economy (some sales are postponed, some are lost forever). In any case, much of the March economic data will be revised. So take it all with a grain of salt.


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.

All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.

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