With sovereign and political issues taking centre stage in markets recently, macroeconomic indicators have taken a back-seat in many market participants’ minds. But how have the advanced economies been recovering, absent these risks? Today I’d like to focus on some research on labour markets that was recently published by the International Monetary Fund (IMF) in their World Economic Outlook and the implications this might have on central bank interest rates.
Unemployment is a big problem at the moment and is a key challenge for policymakers globally. Strong labour markets generally result in higher consumption and wealth effects, generating higher standards of living and stronger GDP growth. Given this context, the IMF has sensibly asked: how long before employment recovers?
Sadly the employment reports to come out of the US, Europe and the UK have not made for comforting reading. In the US, the unemployment rate jumped to 9.9%, despite the fact that more jobs were created than in April than in any month in the past four years. In Europe, there are 23.1 million people out of work, and unemployment is still rising in 26 out of the 27 member states (the unemployment rate has fallen in Germany however, showing the unsynchronised nature of the economies within the Eurozone). Finally, the UK has 2.51 million people looking for a job – the highest level since December 1994. The UK unemployment rate, at 8 per cent, is at a level that has not been seen for sixteen years.
To help us assess the current state of labour markets in an historical context, the IMF has analysed unemployment developments in recessions and recoveries over the past 30 years in a number of advanced economies. Being economists, they have a rule to assist them in organising their analysis called Okun’s law. It’s basically the relationship between the unemployment rate and GDP. If the unemployment rate rises in a country, then its GDP will fall. If unemployment falls, GDP goes up. Pretty simple really. According to Andrew Abel and Ben Bernanke (Chairman of the U.S. Federal Reserve), estimates based on data from more recent years give about a 2% decrease in output for every 1% increase in unemployment.
The IMF has found that ‘the responsiveness of the unemployment rate to changes in output has increased over time for several advanced economies, due to less strict employment protection and greater use of temporary employment contracts’. The IMF suggests that Okun’s law – the responsiveness of the unemployment rate to changes in output – has increased over time. Labour markets are now suffering more in a downturn leading to higher unemployment levels, but in the upturn phase of the business cycle labour markets can improve quicker than they used to.
It’s an interesting analysis but the key findings for me are as follows. If we look at the chart by the IMF on the experience of the last 30 years the unemployment rate peaks 5 quarters after a “standard” recession, 6 quarters after a recession caused by a financial crisis, and 5.5 quarters after a recession caused by a house price bust. Employment tends to trough before unemployment peaks except during recessions caused by financial crises. In these recessions employment troughs and unemployment peaks 6 quarters after the economy returns to positive growth.
The recent readings in unemployment and employment are consistent in these findings. Taking the US as an example, we saw a large number of jobs created in April yet the unemployment rate increased. Why was this the case? It is because the participation rate increased, meaning that more people were actively seeking work. This is what economists call the “encouraged worker effect” – people outside the workforce seeing the economy improve and deciding to actively look for a job.
The IMF analysis is important, as we now know that the US and Europe exited their respective recessions in Q3 2009; and the UK registered positive growth in Q4 2009. Based on the IMF conclusions we can reasonably assume that unemployment rates in the US, Europe and the UK are unlikely to peak until around Q1 or Q2 2011, suggesting a deteriorating labour market and high unemployment rates for the remainder of 2010. Additionally, as we know from our discussion of Okun’s law, the unemployment rate responds to positive growth. With current unemployment rates ranging from 8 to 10 per cent Okun’s law suggests that we need to see a 2% increase in output above trend growth (trend growth is estimated to be around 2-3% for the major economies) to see a 1% fall in the unemployment rate. Is this really going to happen anytime soon?
If we turn now to an analysis of when the Federal Reserve raises interest rates after a loosening phase of monetary policy, we can see in this chart that the Federal Reserve tends to hike interest rates around 8 months after a peak in the unemployment rate. Using this as a rough guide as to when the Federal Reserve might start to raise interest rates from their historical low levels, an interest rate hike by the Fed is now moved out to around Q4 2011. Current market pricing is for a rate hike from the Fed in 6 months time in around Q4 2010. This looks like it could be too early given the IMF and our own analysis of past recessions. What are the implications for global interest rates if the central bank of the United States doesn’t hike rates until Q4 2011?
The reason I have focussed on the US is because it arguably has the best economic growth outlook at the moment from a fundamental standpoint. Key leading indicators like business confidence, housing starts, consumer confidence and retail sales look like they are recovering and have largely been beating economists’ forecasts over the course of 2010. Given the US does not have the concerns that Europe currently does over sovereign risk or the political and budgetary concerns of the UK, it may be the case that the Federal Reserve leads the European Central Bank and the Bank of England in hiking interest rates from their current historically low levels.
I suspect that the central banks will want to make sure that the recovery is self-sustaining, as indicated by rising employment levels and falling unemployment rates. Central banks want to see labour markets improving before they risk killing off the economic recovery. Given below trend economic growth, the absence of wage pressures and the limited pricing power of corporations to pass through rising producer prices to consumers, it is unlikely that inflation will be an issue in the short-term. In this type of environment I think that the Fed, ECB, and BoE will keep interest rates lower for longer than the market and economists currently expect.