NEW YORK (TheStreet) -- Chase Chief Economist Anthony Chan tells TheStreet, Inc. (TST) that the U.S. labor market is poised for a rebound in 2014. And while the pace of job growth just doesn't feel fast enough, Chan, an economist at the Chase unit of JPMorgan Chase (JPM), says the prognosis is largely positive and improving heading into the coming year.
The U.S. unemployment rate recently dropped to 7%, a decline that many argue is skewed to a weaker labor force participation rate. But Chan, who also serves as a managing director at JPMorgan Chase, pulls up metrics derived from capital equipment expenditures and the participation rate that underscore the flaw in this line of thinking. The hard numbers, Chan argues, not only illustrate that labor weakness is concentrated in one particular group under temporary labor slack conditions, but that job opportunities could accelerate in the U.S. in the coming year.
The improving economic conditions, Chan says, is in no small part due to the $85 billion a month Federal Reserve bond-buying program. The stimulus has enabled the U.S. economy to gradually regain most of the 8.7 million jobs lost during the financial crisis. In his most recent winter report delving into the 2014 U.S. economic crystal ball, Chan notes that signs of an improving U.S. economy are lifting consumer sentiment and stock market values despite the temporary setback from the closure of the federal government.
Chan commented that housing and consumer spending are two areas that have benefited the most from government stimulus. By extension, these two sectors have been important contributors to real gross domestic product growth so far this year.
Heading in 2014, Chan is expecting a calm on the fiscal front, hopeful that next year won't see a repeat of the fiscal drama out of Washington punctuated by the October government shutdown.
With that in mind, Chan told TheStreet over the phone that even as the economy keeps strengthening, the Federal Reserve under Janet Yellen would approach the subject of tapering with balance, flexibility and sensitivity. That should prevent any residual shocks to the market when the action does take place.
Chan points out that signs of that flexible approach in fact are already emerging as outgoing Fed Chair Ben Bernanke hands over the reins to Yellen. Although the jobless rate declined last month to the 7% guidepost Bernanke highlighted as the mark of the conclusion of the central bank's asset purchasing program, the wind-back hasn't even begun yet, highlighting the flexibility with which the Fed can maneuver on its tapering timeline, Chan remarked.
It's an extremely tough balancing act. But given Yellen's easy monetary stance coupled with a deep sensitivity to inflationary risks, and combined with the integral role she has played in shaping the Fed's directive towards transparent communications, the soon-to-be central bank chair should be an expert in carrying out the delicate act of managing market expectations.
U.S. stock markets plunged the most in 19 months on June 20, a day after Bernanke explicitly laid out details of the central bank's plans to taper its stimulus program and referenced the 7% jobless number, dragging down U.S. equities to their first monthly retreat since October 2012. But "I think this time it will be different," said Chan of the day that the first round of tapering is announced.
Granted, while in 2014 the Fed will continue to show that it can exert control over the tricky act of managing both short and long-term interest rates, inflation will remain the wildcard. Fostering strength in labor market conditions and economic growth will continue to be a primary area of concern for the Fed under Yellen, but Chan says that doesn't mean an increase in interest rates will be protractedly out of the question.
With that, what follows is an exclusive Q&A with Chan on his Fed monetary policy outlook under Yellen's regime, and what's in store for American jobs in 2014:
Andrea Tse: Nonfarm payrolls growth has seen upward revisions for the past several months, but the labor force participation rate continues to show weakness with a slip in the participation rate to 62.8% just in October, the lowest read since March 1978, from 63.2% the prior month. Is the U.S. labor market really headed in the right direction heading into 2014?
Anthony Chan: Well the answer is 'yes.' I do think it's heading in the right direction.
The labor force participation rate actually ended up picking up a little bit in November. So that to me legitimizes at least some of the decline that we saw in the latest unemployment rate. And when you consider that we are creating over the last three months an average of 193,000, the last four months an average of 200,000 -- if you keep creating jobs at that pace, I don't think most people could come to the conclusion that we're not making progress on the labor front. Is it too slow? Yeah it is too slow, but the unemployment rate has come down from 10% to 7%. Not all of that is as real as we would like because as you correctly pointed out, that labor force participation rate did come down [in October]. And it is still too low.
But as the economy gets better, people will in fact start rejoining the labor force. And one of the things I did, since you brought up the labor force participation rate, after the last employment report came out was that I looked at the labor force participation rate across cohorts, and I found that the major cohort that experienced a little bit of the decline was believe or not, was the younger one. The 16 to 24 year olds, the young ones. But others started increasing. So when I see that, that tells me that this is not a problem that is as bad as some people make it out to be. When you look at people in the 25 to 34 year olds, that labor participation was around 7/10. It's now 81.2%. It's also 82.1% in the 35 to 44 year olds.
What you're seeing at that young age is that the economy is being transformed. People with relatively little skills are facing real challenges out there, and some of them believe or not, are just dropping out of the labor force to go back to school, in hopes they can improve themselves, and get better jobs. That brings down the average.
You saw yesterday [Monday, December 9, 2013], the Federal Reserve reported a surge in the household net worth. We lost over $13 trillion worth of wealth during the financial crisis, terrible thing. But with housing prices going up, and with the stock market going up, we made it all back. And we made another $8 trillion on top of that. So that means that the more mature cohorts, they're now able to retire. Before, a lot of those more mature cohorts may have wanted to retire, but after losing all that wealth, they said, 'hold on, we'll have to stay working longer.'
So now their labor force participation rate is probably going to continue to come down and when you add that to the younger cohorts who don't have the skills and stay in school longer, that's what's keeping it down. But I would say that as these younger cohorts start graduating and become more productive, I think we'll all be better off. It doesn't feel that way yet now, but it will. I think somebody who decides to go back and get their degree, I think they're going to better off if the economy continues to improve. And that goes to the forecast. We're going to grow less than 2% this year, and I think next year we're going to grow in the neighborhood of 2.5% or slightly more, so we are making progress even though it's not fast enough for most people including myself.
Tse: One job creation metric said to be accurate is the ratio of how much banks are willing to lend to the willingness of small businesses to borrow. What do you think is the most reliable calculator of job creation and what is that indicator modeling for 2014?
Chan: One of the most important metrics for me is capital equipment expenditures. When capital equipment expenditures strengthen, that usually is a precursor to increased hiring. Of course economic growth is also a precursor. If you grow faster, you're going to demand more jobs. But capital equipment is important. And it has been weak, but if you look at some of the surveys out there, it suggests that it's going to be picking up in 2014. So that's why I think we're going to have an impressive employment year in 2014. I think it would be better even than in 2013.
And again, when we say it's not good enough, frankly speaking, I think we're creating enough jobs. We're creating more jobs than the growth on the labor force. The problem is, we have a lot to catch up on. When you lose 8.7 million jobs, you can't wake up the next day and say 'oh, things are okay now.' You have to obviously make up for all those jobs you lost, plus all the jobs that are required to absorb that natural growth in the labor force. We dug ourselves in such a deep hole after the terrible financial crisis that it almost feels like we're not. But we are, we've made a lot of progress.
Tse: Fiscal headwinds is also a major area of concern for investors. To what extent do you think 2014 will see a repeat of 2013's fiscal headwinds?
Chan: Well I think that the major hit and the major negative impact was in 2013. We had the payroll tax increase, we had the sequester. Now that's pretty much baked into the cake. Into the overall economy. So I don't envision that that will be as much of a headwind. That's true in the U.S., that's true in Europe. The negative fiscal headwinds are in fact dissipating. And so I think that they will be a less of a hindrance to growth both here and in Europe. Economic growth in 2014, that's a pretty big positive.
And then if we end up with a budget deal, where we'll be able to ease some of the pressures of the sequester, and we'll find out, because the deadline is Friday for them to be making some sort of a decision [fiscal talks in progress as interview took place]. I think that you'll take that big level of uncertainty and that will unleash even more economic activity if we somehow make a deal. Even if it isn't a grand deal, but some sort of a deal, where you remove some of the uncertainty off the economy, I think that will go a long way.
Tse: Between job creation and other factors, which do you think could be the tipping point that could cause a delay to the first wave of Federal Reserve tapering to further out than the March 2014 meeting? And of course, at this point, it doesn't look like fiscal gridlocks will be a tipping point factor to consider.
Chan: Well, if we have some sort of a fiscal deal, it clearly won't be that one, right. And I think we're moving in a direction of getting a fiscal deal. Patty Murray and Paul Ryan seem to be at least leaning in the direction of signing some sort of a deal [budget negotiations underway at time of interview], so I think it has to come down to either a collapse in economic activity or collapse in job growth, but when I look at all the indicators out there, they do suggest to me that we are moving in the direction of showing continued improvement on those fronts. We are seeing job creation even if people think that everything is all tied to the labor force participation rate. That's just one way to look at it.
I think when Janet Yellen takes to helm, she'll take a more holistic view of the labor market. I mean they'll be looking at a lot of things: average hourly earnings, to see if they're accelerating, because that's a sign that the labor market is tightening. They'll be looking at how long when you get laid off does it take you to find a job.
To some extent, you can make the argument that a policymaker is constrained when they give you the reaction function and they put it into one or two variables whether it's inflation and the unemployment rate, and you get limited to that, and when there are distortions in the way you measure those numbers, that becomes a little problematic. That's why I think the Federal Reserve needs and is in fact taking advantage of some flexibility within that reaction function, and the flexibility is they didn't really start tapering even though the unemployment rate has been coming down, because of other extenuating circumstances.
Remember when the Fed announced they would end quantitative easing when the unemployment rate went down to 7%. Well guess what, we're at 7% now. We haven't even started. So when somebody tells you the party gets started at 10 o'clock and ends at 12, and it's one o'clock in the morning, you start thinking, is there really going to be a party? So now I know the answer.
Tse: By the March meeting, Janet Yellen will likely already be the new Fed Chair. Can you talk a bit about how Yellen will likely handle the delicate balancing act of giving guidance based on current expectations while being reactive to the way that the data might change?
Chan: Well I think she will in fact have to lean heavily on the levers of forward guidance.
And in an environment where the Federal Reserve seems pretty anxious to start the tapering -- and somehow they're not able to manage that process with better or strong forward guidance -- that could be a problem. We saw that problem developed when the financial markets reacted in a hasty fashion in response to the initial words or the initial signals that tapering would occur.
But I think now the Fed, not just Janet Yellen, but the Fed has done a lot of work, has chopped a lot of wood in trying to make sure that the message is loud and clear that if they start tapering, that doesn't mean that they're automatically embarking on a major tightening move or a tightening strategy. And I think they've done that and I think Janet Yellen will just continue much of the work that has already begun. Remember, she was in charge of the communications strategy of the Federal Reserve. So if somebody's in charge of the communications strategy, I think that they will probably be more than well qualified to make it even better because that was one of her responsibilities.
Tse: How will the FOMC under Yellen's leadership go about managing the tough act of tapering and removing the stimulus in the long end of the curve while still holding tight on the short end?
Chan: Well, she's an academic as you know and academics will tell you the pure expectations hypothesis of interest rates is that long-term interest rates are a some sort of average of current short-term interest rates and future short-term interest rates plus a term premium. So if they do a good job by giving you an idea of what the path of short-term interest rates are, then you should be able to conclude that that will have some bearing or have some strong impact on long-term rates. And so if the forward guidance is acceptable and adequate, the Fed will continue to have some control over long-term rates.
I know that everybody debates this back and forth that somehow the Fed has no control over long-term rates. All they do is control short-term interest rates. I never have believed that. To say that they have no control over it, that's a little bit too far.
If inflation is going to escalate and people get nervous about the Fed and they think they're going to pursue inflationary policies in the future, then obviously that term premium, or uncertainty premium could escalate. And that's what the Fed doesn't have perfect control over. But you should never say, and Sean Connery always says, 'you should never say never.'
Tse: Yellen has, of course been classified as "dovish" by the mainstream media. Given the changes in economic conditions that could occur down the line, is there a risk in assuming that low interest rates will be prolonged under her monetary policy regime?
Chan: I think that it's fair to say that the perception is that if Janet Yellen were to err, she would err on the side of being more dovish rather than being less dovish. And more dovish rather than being hawkish. But, I think at the end of the day, Janet Yellen, like the rest of the Federal Reserve understands that one of their mandates is to keep stable prices.
Now does that mean that she will raise rates more aggressively than others or less aggressively than others? What I gather from everything I know about Janet Yellen is that she thinks that labor market conditions and economic growth is important and if it's a toss-up of some kind as to whether or not to continue easing or continue to follow an easier policy or start tightening policy, I think most people would agree with me in saying she probably would err on the side of being a little bit easier, more dovish, but I don't think that you can define Janet Yellen as somebody that doesn't care about inflation.
She's going to be cognizant of inflationary pressures and react accordingly even if at the margin she might tilt more in the direction of stimulating the economy.
Tse: When the Fed makes its first tapering move, are you expecting a real U.S. equity market correction as the S&P 500 this year continues to log its strongest performance since 1997? Or could there be a fairly muted, or on the upside, even positive response from the U.S. equity market should the central bank manage the tough balancing acts successfully?
Chan: I love that question because that's the same question that a lot of clients have on their monitor, and the answer is, I think this time it will be different. Because when they first announced the possibility of tapering, I think it was fair to say that financial markets were less confident about the economic outlook for the U.S. and maybe even for the global economy. Now that we see that the U.S. and the global economy seems to be showing further signs of life, I think that financial markets are going to be less fearful of Fed tightening.
So although financial markets never really like to see less rather than more liquidity, they won't react as negatively to a tapering act in an environment where things are in fact getting better. If the patient is much healthier and you're still giving the patient antibiotics and you cut the dosage a little bit, I don't think the negative impact is all that great. You might see a little bit of a negative reaction in the equity markets. But I'm pretty confident it won't be as severe as it was in May and June, when they first broached this idea.
And by the way, we're not talking about eliminating the Federal Reserve purchases by $85 billion a month. We're talking about cutting it $10 billion is what the consensus is expecting and even the thinking out of the box forecast of $15 billion, when you're looking at $85 billion, even if you took 15, it's not over. If it turns out to be just $10 billion, I mean we could live with it for a while.
And as they strengthen the forward guidance, which I think Janet Yellen would do, then I think the markets will say 'well, they are in fact going to do this, but they're going to rely on other tools.' And the other tools are keeping short-term interest rates at low levels for maybe a lot longer and to some extent that will cushion the blow of Fed tapering.
If the communications strategy succeeds, and I think it should, the markets will get the impression that Fed tapering is not tightening and so the end-all result will be that the markets react less negatively than they have in the past, and at some point, with less uncertainty, I think that the markets could very well rally with the announcement. The impact could end up being positive for the markets.
--Written by Andrea Tse in New York.
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This interview has been condensed and edited.