The Fed on Unemployment and the Future

There are some mixed signals coming from the Fed regarding unemployment.

This week Chairman Powell said, regarding FOMC projections from its September 26 meeting, that “From the standpoint of our dual mandate, this is a remarkable positive outlook…Since the 1950s, the U.S. economy has experienced periods of low, stable inflation and periods of very low unemployment, but never both for such an extended time as is seen in these forecasts.

Of particular note was its projections of the unemployment rate going forward:

Criticisms of structural weakness in U.S. employment aside, the market today is quite good for the American worker. It’s so good, in fact, that wages for low-skilled labor—like Amazon’s warehouse workers—are finally on the rise. Some are concerned that price inflation will result as companies try to pass their rising costs through to customers. Since sluggish wage growth has been a puzzle at the Fed for some time and it believes inflation is still muted, such developments are still likely welcome news.

To achieve that growth has taken an especially low unemployment rate (which is likely linked with low productivity growth, which we have discussed here). Currently, it sits at 3.7%. That the Fed sees that number low for so long into the future is curious given a June report this year by the Federal Reserve Bank of St. Louis.

It examines the use of the unemployment rate as a signal for recession. In particular, it examines the trough in unemployment relative to the beginning of recessions back to 1969.

On average, the unemployment rate trough has occurred nine months before recession, with a maximum occurrence of 16 months and a minimum of one. This makes it an even more reliable indicator than a yield curve inversion.

The trouble is, of course, knowing where the trough is. Further, unemployment does not move in a linear fashion and a uptick does not necessarily mark a reversal.  What we can say is that the average cyclical low for the last seven business cycles since 1969 is 4.9%. We are well below that now and only one of the last seven business cycles has seen the lowest print below the current level.

The Fed’s current unemployment projections maintain even lower rates some 36 months into the future. Only 1966­–1969 is precedent for such an outcome. Not only were other economic variables quite different then, but unemployment moved much higher afterward, far exceeding the Fed’s longer term expectation of 4.5%.

The Fed is saying that against the historical norms of its own research, we are living in unprecedented times. Low inflation and low unemployment, despite low growth in productivity.

Also unprecedented are the valuations at which stocks trade today and the amount of debt corporations hold. If the Fed’s projections turn out to be wrong, it could be a difficult road ahead for the economy and, by inference, the securities markets, which are priced for perfection.