Focus
August 16, 2024 | 12:47
Why Jay and Tiff Worry (More) about Labour Markets
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Economics
Why Jay and Tiff Worry (More) about Labour Markets |
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Last month’s policy announcements by the Federal Reserve and Bank of Canada both featured prominent mentions of the latest labour market developments alongside conspicuous signals of more policy weight now being put on labour market (and broader economic) conditions. The policy weight shifts reflect the meaningful progress already made in pulling inflation down from its 2022 peaks (Chart 1) and the increasing confidence both central banks have that their 2% targets, in sight at the end of a still bumpy road, can be reached. And they, critically, reflect the deterioration in labour market conditions that seem to have reached a ‘tipping point’ from a risk management perspective. Among the many pre-pandemic inflation battles waged by both central banks, such a policy weight shift likely wouldn’t have happened as early, or at all. Widespread joblessness and recessions were considered the painful but necessary ingredients for speedy disinflation. However, changes to the Fed’s monetary policy framework in 2020 and to the Bank’s in 2021 altered how each institution approaches the trade-off between disinflation and labour market/economic languor. The central banks are now attempting to avoid any more weakness than is necessary to restore price stability. |
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About last month…The Federal Reserve kept rates unchanged on July 31, marking the one-year anniversary of its last rate hike with a major change to the policy statement. Amid an uncertain economic outlook, it said “the Committee is attentive to the risks to both sides of its dual mandate”. This replaced the phrase about the Committee being “highly attentive to inflation risks” that had been in place since Chair Jay Powell’s seminal “Restoring Price Stability” speech in late March 2022. And like that speech, this, too, was a pivotal event. From a risk management perspective, deteriorating labour market numbers are now getting equal billing with improving inflation figures. Although “more good data” on the latter was still a rate cut requirement, the bar is likely lower now with the inclusion of data catalysts from the labour market side and, importantly, Powell revealing little tolerance for additional deterioration. He said: “I would not like to see material further cooling in the labour market, and that’s part of what’s behind our thinking.” Unfortunately, that’s what he saw out of the post-confab gate. For example, the jobless rate jumped two-tenths to 4.3% in July, now up a large 0.9 ppts from its cycle low 15 months earlier (Chart 2). |
The Bank of Canada cut its policy rate by 25 bps on July 24 for the second consecutive meeting, leaving the door for further rate cuts wide open and revealing an increased willingness to cross the threshold. Since January, the Bank has been acknowledging that the economy was in “excess supply” with disinflationary consequences. However, for the first time in the latest policy statement, this was matched with an acknowledgement of excess supply specifically in the labour market. It said: “There are signs of slack in the labour market. The unemployment rate has risen to 6.4%, with employment continuing to grow more slowly than the labour force and job seekers taking longer to find work.” The specific mention of the jobless rate was telling, which is up a huge 1.6 ppts from its cycle low two years earlier (Chart 2 again). (Released after the BoC, July’s unemployment rate remained at 6.4%.) |
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With the labour market now corroborating excess supply, the Bank shifted its policy easing gears. In the press conference Governor Tiff Macklem said: “With the [inflation] target in sight and more excess supply in the economy, the downside risks are taking on increased weight in our monetary policy deliberations. We need growth to pick up so inflation does not fall too much, even as we work to get inflation down to the 2% target.” (All underlines are ours.) While this wasn’t an easing carte blanche (inflation outcomes still matter a lot), one gets the sense that further rate cuts will now only be dissuaded by the data, cuts no longer need to be persuaded by them. The Bank added: “If inflation continues to ease broadly in line with our forecast, it is reasonable to expect further cuts in our policy interest rate.” Fiddling with frameworksFor both central banks, the increased policy weights now being applied to labour market outcomes mirror the changes made to monetary policy frameworks during the past few years. The Fed’s framework is laid out in the Statement on Longer-Run Goals and Monetary Policy Strategy. This was first introduced in 2012 with the adoption of a 2% inflation target as the means to achieve the goals of price stability and maximum employment mandated by Congress. On the second goal, the Statement said: “The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee’s policy decisions must be informed by assessments of the maximum level of employment…” Subsequently, the combination of chronic inflation underperformance (compared to the target) along with historically tight labour markets during the 2017-2019 period—that didn’t pump broad inflation pressures but saw wider social dispersion of job and wage gains—were the backdrops for the changes announced in August 2020. The Fed switched to average inflation targeting. After a period of persistent below-target inflation “appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time” so that inflation “averages 2 percent over time”. “Time” was not defined (affording flexibility) and this was not intended to be a symmetric regime (whew!). The new Statement also asserted: “The maximum level of employment is a broad-based and inclusive goal that is not directly measurable and changes over time owing largely to nonmonetary factors that affect the structure and dynamics of the labor market. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee’s policy decisions must be informed by assessments of the shortfalls of employment from its maximum level…” This means that a historically tight labour market will no longer trigger policy tightening unless it’s associated with mounting inflation pressure. And, given the “broad-based and inclusive” interpretation, policy will strive for the strongest labour markets possible, considering inflation. The Bank of Canada’s monetary policy framework is the result of the ongoing agreement with the Government of Canada. It was last renewed in December 2021 to run until December 2026. The cornerstone is an inflation target of 2% (which has been around since 1991) inside a control range of 1% to 3%. The regime is “symmetric” and “flexible”. On the former: “the Bank is equally concerned about inflation rising above or falling below the 2% target.” On the latter: “the Bank seeks to return inflation to target over a horizon of six to eight quarters. However, the most appropriate horizon for returning inflation to target will vary depending on the nature and persistence of the shocks buffeting the economy.” |
Importantly, this renewal changed how flexibility can be leveraged. The Bank will “use the flexibility of the 1%-3% control range to actively seek the maximum sustainable level of employment, when conditions warrant. The Bank will also continue to leverage the flexibility inherent in the framework to help address the challenges of structurally low interest rates by using a broad set of policy tools. The Bank will use this flexibility only to an extent that is consistent with keeping medium-term inflation expectations well anchored at 2%”. This means, should inflation trends fall within the control range (Table 1) and the Bank is confident disinflation will continue (and medium-term inflation expectations aren’t jeopardized), the Bank is now more likely to respond to worrisome weakening in the labour market. |
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What does this mean?In the wake of last month’s policy announcements, we adjusted both our Fed and BoC calls. We pulled forward the timing of rate reductions with a steady stream of cuts into early next year before a slower cadence unfolds. But, given the announcements—along with the labour market (and inflation) data that triggered them and the modified policy frameworks that compelled them—the net risk is that the Fed and Bank could cut rates even more aggressively. |