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(Reuters)

Slacking Toward a Rate Hike

By Economic Indicators FOXBusiness

Everyone knows there is ‘slack’ in the U.S. labor markets, a condition Federal Reserve economists define as “the degree to which labor resources are being underutilized.”

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In less technical terms, slack is caused when lots of able-bodied people are looking for full-time jobs with solid wages and benefits but can’t find them.

The question is how that slack will impact the central bank’s decision on the timing and trajectory of interest rate hikes. And the answer is: A lot.

Job market slack will come into sharp focus again on Friday when the U.S. Labor Department releases its November employment report. The data is expected to reveal another solid month of job growth, building on momentum gained through the first three quarters of 2014 when the economy gained an average of more than 200,000 jobs each month.  The consensus among economists is that 225,000 new jobs were created last month, and the unemployment rate will fall slightly to 5.7%, its lowest level in six years.

But the rapidly-declining unemployment rate has belied a number of significant issues that have bedeviled labor markets since the economy faltered during the 2008 financial crisis. In short, millions of Americans who have returned to the workforce since that time have taken jobs that are either part-time, temporary or well below their qualifications.

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This has created a large pool of surplus workers who, while not unemployed, are actively seeking better paying jobs. This surplus has led to the slack that has reverberated through the broader economy by keeping wages low because employers, keenly aware of the surplus, don’t need to offer higher pay to attract employees.

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Uneven Labor Market Recovery

A recent report by the Federal Reserve Bank of San Francisco noted measures of labor market slack rose to “unprecedented levels” immediately following the financial crisis. But as the economy has slowly recovered, the rate at which those measures of slack has improved is not quite balanced.

“The uneven recovery across these measures has increased uncertainty about whether the economy is approaching or still far from full employment. Such uncertainty represents an important challenge for policymakers trying to decide on the appropriate course for monetary policy,” the report states.

Fed Chair Janet Yellen has repeatedly cited labor market slack for her cautious approach toward phasing out the central bank’s stimulus policies initiated in the wake of the financial crisis. For instance, Yellen has said interest rates won’t move higher until inflation hits the Fed’s 2% target, which won’t happen until higher wages push prices higher. And that won’t happen until labor market slack tightens.

The monthly jobs reports throughout 2014 have shown labor participation rate, a key gauge of the proportion of the population employed or seeking employment, is running at its lowest level since the late 1970s. The rate stood at 62.8% in October and isn’t expected to have risen significantly in November. Wages are also expected to have remained essentially stagnant last month.

U.S. Labor Force Participation Rate Over the Past Decade


Source: U.S. Department of Labor

David Kelly, chief global strategist at JPMorgan Funds, cites five reasons why fewer Americans are working: Retiring baby boomers; younger people seeking higher levels of education rather than going to work; a rise in the number of people on disability; large numbers of discouraged workers; and the exclusion of people with criminal records.

Because these reasons are structural -- as opposed to cyclical -- in nature, caused by shifts in U.S. demographics that won’t change even as the economy grows, Kelly said these groups of people won’t be returning to the workforce once the economy does strengthen.

“They’re not going to just get up off the couch and rejoin the workforce,” he said.

A Positive Development

Consequently, when economic growth reaches a level where employers have to hire new workers, Kelly expects the slack that currently exists in the labor force to tighten up, perhaps quickly. The effect of that tightening will be higher wages and ultimately a boost in prices and inflation. And when inflation starts to rise it will put pressure on the Fed into making a decision on raising interest rates.

“If low (labor force) participation rates are being driven mainly by demographics rather than economics, then faster economic growth will not boost them,” Kelly said. “The structural drags imply that the U.S. will quickly absorb its remaining labor market slack – contributing to more significant inflation pressures and more rapid Federal Reserve tightening than markets currently expect.”

This is a positive development for the economy, Kelly added, but it shows the Fed is “running out of time” to make a policy decision.

Kelly said he expects economic growth to push the unemployment rate down to about 5% by late 2015, at which point the Fed will likely decide to move rates higher.

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