The Federal Reserve this week passed on raising interest rates again, and many investors seem unhappy about it. We hear them say things like "The Fed is behind curve" or "The Fed is losing credibility." But can someone please explain what Fed policymakers are behind the curve on? The Fed will not raise rates this year, and we've explained why here, here, here and here. Let's explain why again.
When considering the U.S. central bank's policy decisions, you must keep in mind that its legal mandate is to maximize employment and maintain price stability.
First, let's look at the employment situation. The rosy U-3 unemployment rate of 4.9% -- the one that gets all the headlines -- is not a true indication of the job market. The more accurate U-6 rate is at 9.6%. The labor participation rate is at 62.7%. It's true that it's up from January's 62.3% reading, but someone forgot to mention it's still down from the 63.2% reading of July 2015. The chart below shows the number of jobs created every year since 1948.
We have created on average 1.5 million jobs a year since 1948. Do you know how many jobs were created in 1950? 3.3 million. In 2015? 2.7 million. We are creating approximately the same number of jobs annually today as we did in 1950. There is one problem. In 1950 there were 62.2 million people in the labor force. In 2016 there are 157.1 million. So let's adjust the chart for population.
In 1950 the 3.3 million was 5.36% of the labor force. In 2015, 2.7 million is only 1.7% of the labor force. Simple math tells us we need to have 4.7 million jobs created a year just to get to 3% of the labor force, forget about 5%.
You might wonder whether the labor participation rate is down because of shifting demographics and retiring baby boomers. Not exactly. Workers that are 55 and older are working longer or seeking new employment. Meanwhile the 16-54 age group's population is growing, but jobs are being lost.
So we have inadequate job creation, and a portion of the labor force unable to find work. That seems to solve the labor participation myth. Still feel good about 4.9% unemployment?
What about the other side of the Fed mandate, inflation? From the chart below we can see that for most of the 1990s and 2000s the Fed was content with inflation in the 2%-3% range. We haven't been able to get above 2% since 2008-2009.
The chart below shows the velocity of MZM. This is nominal gross domestic product divided by the MZM Money Supply, which is considered to be the broadest measure of money supply. Velocity essentially measures how quickly one dollar moves through the economy, but it can be useful to think of it in another way: as a return on investment or a yield. The chart tells us that every dollar of MZM created in the late 1970s and early 1980s created $3.55 in GDP. In 2015 every dollar in MZM created $1.35 in GDP.
So why should we think of the velocity of MZM as a return on investment or a yield? Because since 1959 it has been 92.7% correlated to the interest rate on the 10-year Treasury, with an R^2 of 0.86, making it statistically significant. It's true that correlation can exist without causation, but I'm willing to take a chance and say there must be causation somewhere with nearly 60 years of data.
Perhaps it could be strongly argued that the velocity of MZM is the gauge from which Treasury rates are derived. If this is true, then we are engulfed in a period of disinflation, meaning lower and lower inflation rates.
How does this downward cycle stop? There are two ways. You shrink the money supply, which seems like a very painful way to stimulate inflation. Or you can have a combination of fiscal policy and monetary policy in which there's less debt creation (or a reduction of existing debt) combined with massive amounts of MZM creation, or quantitative easing, something discussed here.
After reviewing all of this, do you still think the Fed is behind the curve?