Draghi stole the show at Jackson Hole

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Forget summer festivals like Glastonbury, the place to be this summer was the central bank conference in Jackson Hole, Wyoming. Well, maybe not – but it is still an important event in the world of central banking. It may be less important since the days when then-chairman Ben Bernanke would make major policy announcements but it remains an important insight into the thinking of central banks.

The keynote speech from the Fed chair is always a focus for the markets.

Some commentators thought that Fed chair Yellen was slightly more hawkish. Or to be more precise, that she was marginally less dovish. In fact, she has not changed at all. The data changed, and chair Yellen has always said that the Fed would react to the data. The data is now better, so unsurprisingly she sounds less dovish. The market acts as if this is a change because they are always seeking certainty from central bankers; a certainty that they cannot possibly provide.

One thing that has definitely remained unchanged is that chair Yellen is not convinced that the unemployment rate tells you everything you need to know about the health of the labour market. She pointed instead to a recent working paper from the Federal Reserve, which constructed a composite index of labour market conditions. This index shows that conditions are improving but they are a long way from pre-crisis health.

The 19 indices are grouped into nine characteristics of the labour market. With the exception of the rate of layoffs and vacancies, all of these remain much weaker than they were in the happier pre-crisis days of 2006. So should the Fed wait until the labour market is back to full strength, as chair Yellen seems to suggest? The hawks would say that is too late. After all, do you only hit the brakes after you pass your destination, or do you start slowing down  beforehand?

Chair Yellen is well aware of this argument, but for her the answer will depend on inflation. Inflation is unlikely to show a sustained rise unless wages start to rise, and wage growth is something she is concerned may take a long time to materialise.

In fact, it might be that wages have already been too high. This may sound odd given how long wage growth was at nearly zero, but to an economist if the unemployment rate has jumped it suggests wages should have been lower. But wages could not fall because people resist nominal wage cuts (called nominal wage flexibility). The ‘shadow wage’ that would have prevailed without nominal rigidity may be rising as the labour market improved, but if it is still catching up then it will be some time before wages rise. Hence chair Yellen’s expectation that wages may not rise as quickly as past experience would suggest. The hawks may be left chasing shadows.

The big Hole

Despite Jackson Hole being a US conference, Mario Draghi, the president of the ECB, stole the show. His opening act was to compare the unemployment rate of the eurozone with the US, demonstrating the familiar story that the US has improved significantly but the eurozone has not. So much, so familiar; but hidden away in a footnote he pointed out that the drop in the US participation rate explains a lot of the divergence.

Because so many people in the US stopped looking for work, whether due to retirement, education or inability to find a job, the number registered as unemployed looks very low (see EI “Taking Part”). Combined with the small rise in the participation rate in the Eurozone, it explains even more.

Perhaps austerity had such an impact on disposable incomes that more people in the Eurozone had to look for work. Perhaps people in the US gave up on job searches. But whatever the reasons, the difference in participation rates has a big impact.

If you hold participation rates constant at their 2006 levels, the US unemployment rate is almost identical to that of the eurozone – in fact, slightly higher. So does this mean the eurozone is not actually as bad as it seems?

Alas, no; for two reasons. First, it is more that the US is not as good as it looks (as chair Yellen herself was at pains to point out). And secondly, because most of this is the result of some countries looking really good (such as Germany) and others looking really bad (such as Spain). The relative strength of Germany’s economy and in particular the low level of unemployment amongst young people explains the low German unemployment rate – a rate that is the lowest on record despite the crisis. But what makes this more impressive is that the German participation rate rose thanks to immigration inflows from other eurozone countries with weaker labour markets. Without those inflows, the unemployment rate would likely have been even lower.

In Spain the participation has also increased, but for very different reasons. Fiscal austerity and a recession may have made job searching a must for many people, but changes to make the labour market more flexible are likely to have given more people hope of finding a job. Adjusting for these extra job seekers, Spain’s unemployment rate is indeed lower, but it hardly changes the fact that the unemployment rate is atrociously high.

France and Italy lie between the two, with hardly any change in their participation rate. Both countries have had very disappointing recoveries, and most commentators are blaming their lack of progress on structural reform. More progress on those structural reforms would bring benefits to eurozone growth, but as the experience of Spain shows, these could paradoxically increase the measured unemployment rate.

So on one side we have the ECB, which remains dovish because of a high unemployment rate, and on the other we have the Federal Reserve, which remains dovish despite a falling unemployment rate. The participation rate is the new variable that explains the gap, but the behaviour of wages is also adding confusion. The times when monetary policy decisions could be based on a straightforward look at inflation and unemployment are over.

 

Joshua McCallum is head of Fixed Income Economics at UBS Global Asset Management

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