Wherein Both Delong and Fernald Confuse Me

September 22nd, 2014 at 6:20 pm

Not hard to do–and nothing against either of those big brains–but I’m confuzzled by this post from Brad.

The question–or at least one of the questions–is a) whether there’s hysteresis in play and b) whether reverse hysteresis can be invoked to repair some of the damage. I’m too rushed to go into explanations of terms etc. right now, but John Fernald–my go-to guy on growth theory and evidence–seems to be arguing that hysteresis cannot legitimately be invoked because the slowdown in potential growth occurred prior to the great recession and the damage many of us, including Brad_1, think it did to supply-side inputs (there’s the hysteresis).

Now, Brad_2 seems to be saying he’s not so sure, and–here’s the confusing part–he quotes John as follows (my bold):

Utilization by any empirical measure is where it was a decade ago. And my informal polling of firms doesn’t suggest a lot of slack within companies—they’ve adjusted to the weakness of demand by reducing headcounts and capacity. So you might be offended by the [sharp, sudden] changes in trend, but they’re in the data [and in the world out there].”

Let’s say John’s informal polling is right/representative. Doesn’t that just mean that with greater demand from C, I, G, or X-M they’d adjust to that too, as in reverse hysteresis? Suppose we could lower the dollar and thus the trade deficit, all else equal, or we borrowed a did a big public investment program. Why wouldn’t that increase demand, employment, wages, incomes, and spiritual enlightenment?

By invoking weakness in demand, is John not implicitly saying the constraint is not wholly on the supply side and that reverse hysteresis is possible?

I await reverse confuzzlement by Brad and/or John.

If the lagging labor force rate doesn’t still embody considerable slack, then why does it increasingly predict wage growth?

September 22nd, 2014 at 8:16 am

Here’s another salvo in the great labor force slack debate.

Summarizing what is now a large and growing canon, a lot of digital ink has been spilled over three measly percentage points. That’s the amount the labor force participation rate (LFPR) is down from its pre-recession peak of about 66%, and the big question is how much of it is cyclical and how much structural. The intuition is that the cyclical part—a function of continued job market slack—can be restored while the structural part is gone.

Most work suggests the cyclical part of the gap is falling over time and is now quite minimal, as both the recovery takes hold and “scarring” effects make it tougher for labor force exiters to find their way back into the job market. However, a look at the relationship between the LFPR and wage trends suggests this conclusion may be premature.

A few months ago I reported on some important work by Blanchflower and Posen (B&P) showing that the decline in labor force helped to explain wage trends. Why should this matter? As I wrote back then:

B&P’s finding that including labor force inactivity in their wage analysis helps explain some of the variation…has a very important implication.  If the depressed labor force is a statistically identifiable contributor to slack, then some of the current labor force inactivity can be reversed, much the same way unemployment comes down in the face of strengthening labor demand.  Or, put differently, part of the decline in the labor force is just slack that’s not measured by the unemployment rate.

Here, I’d like to expand a bit on that insight.

First, updating some analysis from a few months ago, see the first figure below. In an analysis designed to show that the unemployment rate still retains some validity as a measure of labor market conditions, Goldman Sachs economists showed how it correlates with recent wage trends (the wage trends are a pooled version of five different series). However, as the red line shows towards the end of the figure, using just unemployment leads to an upwardly biased forecast in recent data. This is not unexpected, as the jobless rate has fallen faster than the underlying slack, a point Chair Yellen frequently makes and a reason she uses her dashboard and other data mashups.

lfpr1

Source: see text

Following B&P, the green line adds the labor force participation rate (LFPR) to the model, which tracks the wage trends more closely and underscores B&P’s point about the cyclical component of today’s LFPR. Even in this toy model, it significantly improves the fit (B&P create a state panel that generates much more data and variance; that’s a much better approach to what I’m showing here—though even this bit of blog-o-metrics makes the point, IMHO).

The next two figures add to the analysis and raise some new points. The first figure shows the coefficient on the LFPR from a “rolling regression,” where starting in 2009q1, I add one quarter at a time. So the first data point in the graph is the coefficient from a model running from 1995q1-2009q1; the second data point is from a model that runs from 1995q1-2009q2, and so on.

Note how the LFPR coefficient climbs as observations are added over the past few years, suggesting that at least in terms of its correlation with wage growth, the cyclical component of the LFPR is growing over time, a finding that stands in contrast with much more detailed decompositions of the LFPR.

lfpr2

Source: see text

Of course, statistical significance matters and the next figure shows the t-statistics from the LFPR coefficients in the prior figure. Importantly, they start out insignificant but gain significance as the weak recovery proceeds, again suggesting that the LFPR is increasingly correlated with the weak wage trends. (Note: As a “falsification test” I ran this model using data back to  the early 1980s and found the LFPR was insignificant and “wrong-signed.”)

lfpr3

Source: see text

While such simple modelling can only be called suggestive, both the increase in magnitude of the LFPR coefficients and its t-stats suggests that our depressed labor force embodies identifiable slack and that Chair Yellen is correct when she argues that a stronger labor market could likely pull some of those sideliners back in.

Data note: the model regresses the pooled wage trend on a constant, the unemployment rate, the LFPR, and an AR(1) term needed to whiten the residuals. I’ll post the data later so others can play with them.

Federal Reserve resists hawkish signal, continues to view economy as needing their monetary support…and that’s as it should be.

September 17th, 2014 at 2:55 pm

The Fed is out with their statement and the words “considerable time” live to see another day!

That makes sense both substantively—the remaining slack in the economy requires continued support from monetary policy—and rhetorically: the Fed’s forward guidance has correctly emphasized that their decisions will be data driven, and the data continue to point toward risk asymmetry: the risk of tightening too soon remains potentially more costly than the risk of wage or price pressures.

Moreover, the Fed’s statement announces, as expected, that barring anything quite unforeseen, they’ll end their QE asset buying program at the next meeting.

So, foot coming off gas but not yet moving over to brake.

The WSJ statement tracker shows little change from the last statement, though what changes there are look dovish, e.g.:

wsj1

And:

wsj2

[And yes, WSJ—your tracker rules!]

Also notable in regards to their take on slack, check out the FOMCs downgrade of their 2015 forecast for real GDP growth. Two years ago in their September meeting, they were looking for 3.4%; last year they marked that down to 3.25%, and today, down again to 2.8%. This too is consistent with the wait-and-see tone of the statement.

fedmarkdown

Source: Federal Reserve

So, once again, kudos to the Yellen Fed for not signaling a more hawkish stance in an economy that still needs their support. Remember, folks: when it comes to economic policy makers still trying to do something big to help the macroeconomy, the Fed’s the only game in town.