Jobs growth is up, and the Fed needs to move

The January jobs report beat expectations, and, coupled with upward revisions to prior months, confirmed that conditions in the job market have improved over the past year. I've argued for most of the past year that the expiration of emergency unemployment claims at the end of 2013 would result in an improvement in the economy (if you pay people less to not work, more are likely to work), and it now appears that this is indeed the case. John Cochrane discussed this recently, and he cites various studies that confirm that unemployment insurance weakens the job market and the economy. The economy is still far below its capacity, but on the margin things are improving—thanks in part to less government meddling with the labor market—and this is very good news.

The relative lack of growth in the labor force (see above chart) since 2008 mirrors the drop in the labor force participation rate (the percentage of the population that is either working or looking for work) over that same period. As the chart above suggests, some 10 million people have simply "dropped out." On the margin this appears to be changing, however, as the labor force rose by 1.1% in the past 12 months, with the entrance of 1.7 million to the workforce. (Over the previous year, the labor force contracted marginally.)

As the charts above show, there has been a noticeable pickup in the growth of private sector jobs over the past year. In fact, the rate of jobs growth now exceeds that of the best years in the previous business cycle expansion. Yes: the jobs market today is doing better (in terms of growth) than at any time in the past decade. So why is the Fed keeping short-term interest rates at zero? That's a good question, and there is only one reasonable answer: because the market is still very worried that the good times won't last. There is still lots of risk aversion and worrying going on out there. The demand for money (cash, cash equivalents, and risk-free assets including bank reserves and T-bills) is still very strong, and the Fed has been forced to accommodate that demand with QE. Banks are apparently very willing to hold on to tons of excess reserves paying only 0.25% because their demand for those reserves is very strong. Similarly, individuals are willing to hold some $7.7 trillion in bank savings deposits (up strongly from $4 trillion at the end of 2008), despite the fact that they pay almost nothing.

But things are changing on the margin. As the chart above shows, bank credit has grown 8.4% in the past year, and it has expanded at a 10.7% annualized pace over the past three months. Over the past year, banks have begun to use their reserves (finally!) to expand their lending activity. Banks are more willing to lend, and businesses are more willing to borrow: Commercial and Industrial Loans are up 13.7% in the past year, and they have increased at a blistering 15.1% annualized pace in the past three months (see chart below).

Given the meaningful improvement in labor market conditions, and the substantial pickup in bank lending, we can infer that confidence is increasing and the demand for money is declining on the margin. That means that the Fed should be moving sooner rather later to raise short-term interest rates (and drain reserves), in order to offset the decline in money demand. The longer it waits, the more the risk of an over-supply of money that could fuel rising inflation.

The current consensus of the market is that the FOMC will raise rates at its mid-June meeting. My growing sense is that's too long to wait. Nevertheless, I'm comforted by the dollar's impressive strength, and the decline in commodity prices, since both reflect a relative shortage of dollars. However, although gold has dropped 5% in the past two weeks (which also suggests a relative shortage of dollars), it is still trading at levels that are roughly twice the inflation-adjusted average price of gold over the past century, and that suggests a substantial over-supply of dollars. So the monetary tea leaves are mixed.

I may just be overly cautious, but I don't see how raising rates to 0.5% or 1.0% in the next 3-6 months could be a bad thing, given how much economic fundamentals have improved over the past year. In any event, it's important to keep in mind that the purpose of moving rates up and down is not to slow down or to goose the economy, it's to keep the supply and demand for money in balance so that inflation remains low and stable. All the signs (rising confidence, increased lending, more jobs) suggest that money demand is declining on the margin, which means the Fed should be moving to offset that decline by increasing the rate it pays on bank reserves, and by draining the supply of reserves.

Posted by Unknown

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