Dear Chairman-designate Yellen:
Congratulations on your being confirmed Monday to become the next Chairman of the Federal Reserve. You will assume office with an interesting confluence of circumstances, with equities having almost tripled from their 2009 lows and with their prices having risen some 30% last year alone. Measured by stock market performance, the Fed’s measures are an unalloyed success. For many players on Wall Street, gifts from Santa have come on a continual basis, not just around Christmas! And you know that the financial players have cheered the Quantitative Easing measures championed by outgoing Chairman Ben Bernanke — steps that you have always supported in your role as vice chairman of the U.S. central banking authority.
Real economy not in synch with the surge in equity prices
But there is also a different side to the story. The real economy — Main Street, if you will — has not only not done as well as financial markets, but has actually done poorly. Even though the economic recovery is supposed to have begun in July 2009, it took until November 2013 for the index of U.S. industrial production to regain the same level it had reached in December 2007, when the recession began. The surge in equities, in other words, has in no way been matched by the industrial sector. Simply put, all the liquidity that was created by the Federal Reserve since late-2008, increasing the Fed’s balance sheet from about $800 billion to over $4 trillion today, boosted asset prices but not the overall economy.
This would still be acceptable if raising financial asset values was one of the objectives of the Fed. However, as you know, the monetary authority’s two mandated objectives are creating employment and maintaining relatively stable prices. Bernanke has justified the Fed’s focus on equity markets by suggesting that the “wealth effect” resulting from higher equity valuations would raise aggregate demand and, thereby, contribute to production and employment. However, real economy data suggest otherwise even as quantitative easing, the Fed’s preferred means of stimulus, enters its sixth year in operation.
Aha, you may say, it took a while, but real GDP did increase at a respectable 4.1% annual rate in the third quarter of 2013, and analyst estimates are being revised up for the final quarter. But haven’t we seen this movie before? Real GDP increased at an even faster 4.9% pace in the final quarter of 2011, only to shift downward to almost zero growth in the final quarter of 2012. And generally, the Fed’s optimistic EOY forecasts have not been borne out in subsequent years. In other words, we have yet to see sustained economic growth even after a quintupling of the Fed’s balance sheet.
Again, such concerns have not hindered the stock market’s rise. When former Treasury Secretary Larry Summers, generally believed to be President Obama’s first choice to be the next Fed Chairman, withdrew from consideration in September, the equity market surged because Summers was thought to favor a faster tapering of bond purchases. The market was further enthusiastic because Summers’ withdrawal made you the favorite to succeed Bernanke, and markets had judged you as a “dove” on monetary policy. Your statement when the President introduced you as his choice to be the next Fed Chairman, and again your responses to questions during the Senate confirmatory hearings, led markets to rise further on hearing that you supported continued easy monetary policy.
Long-term unemployment remains higher than when recession began
Your academic training was as a labor economist, so I would like to approach the issue through the labor market as well. While the Fed takes some comfort from the fact that the unemployment rate dropped to 7% in November — it was as high as 10% of the work force in October 2009 — this level was reached largely through a decline in the labor force participation rate (total labor force as a percent of the working population) to 62.8% in October, and 63% in November, compared to 66% when the recession began. Rather than due to demographic factors — the US population is getting greyer — such a big decline in the participation rate over a few years is more a reflection of workers dropping out of the labor force since they were not getting jobs. The participation rate has not been this low since 1978.
More importantly, if the participation rate today were at 66% as it was in December 2007, the unemployment rate would have risen to double-digit levels. The difficult labor situation is demonstrated by the number of people who are classified as “long-term unemployed,” i.e., those who have been jobless for 27 weeks or longer. There were 4.1 million individuals in that category, compared with the much smaller 1.3 million long-term unemployed in December 2007. The economic recovery that the Fed appears to feel proud about has clearly passed these individuals by.
Structural reforms are essential
While you and other voting members of the Federal Open Markets Committee decided at your meeting last month to taper monthly bond purchases from the erstwhile $85 billion to $75 billion, we also learned of the Fed’s intention to maintain zero interest rates even if the unemployment rate falls to 6.5% or below. With the Fed’s decision, equities — you guessed it! — were again off to the races, with investors viewing the maintenance of zero rates for a longer duration to be a market-friendly development.
I donaEUR(TM)t believe, however, that the FedaEUR(TM)s latest response will be any more successful in promoting sustainable economic growth than the previous efforts were. Why? Though such programs are not part of your mandate, I hope this message reaches both the Administration and policymakers on the Hill: The long-term unemployed, and the 13.2% of the work force that includes people who are jobless or who are limited to working only part-time or have quit the work force in frustration, urgently need labor market reforms. Retraining of workers (and their redirection toward sectors with a healthy demand for workers), incentives for employers to hire additional workers, and vocational training of younger workers will all go a long way toward reducing unemployment. Such structural reforms oriented toward job creation are essential for creating a healthy, productive labor force. These reforms are also necessary for the U.S. economy to realize its full growth potential.
After all, monetary policy has its limitations. If you double the money supply, a plumber will not become an engineer or a nuclear physicist. Only education and training can achieve those goals. To use monetary policy instead of structural reforms will only prolong the period of high unemployment.