Notes From Underground: Why The Fed’s Forward Guidance Model is Flawed

A quick note before we enter the Fed’s two-day meeting. I am reposting a note from a few weeks ago when I conjectured that Chairman Yellen was not the keeper of the Greenspan Put. In the present realm of depressed wages, Yellen would err on the side of allowing corporate profits to soften if it meant an increase of wages for the middle level wage earner. Corporate profits as a percentage of GDP are at elevated levels because capital has been well rewarded from the effects of globalization while the massive increase in the global wage pool has kept downward pressure on wage rates in the developed world economies. Throw in the historical low borrowing rates set by the world’s central banks and the result is enhanced corporate profits. The FED has been enamored with the idea of “forward guidance” and went so far  as to put in a quantitative threshold as a measure of its commitment. The Bank of England has already dispensed with its numeric-based forward guidance and seems to have accepted a more nuanced and qualitative response to its mandate.

The FED has previously discussed its threshold to be an unemployment rate of 6.5 percent as a level of interest but NOT A TRIGGER to automatically raise interest rates. Therefore, the FED will be issuing GUIDANCE on a much more SUBJECTIVE basis heavily influenced by  qualitative measures of what the unemployment data really mean. Ms. Yellen will have room to wait because the 6.5% unemployment rate is not the same as when employment was targeted as a catalyst for creating inflationary pressures. The FED has used the idea of OUTPUT GAPS as a measure of when wage pressures may result in inflation, or what has been referred to as the NAIRU (Non-Accelerating Inflation Rate of Unemployment). If the economy is growing, the probability of slack in the labor pool diminishes and wages will go higher. The problem with the advent of NAIRU was that it came to the fore in the mid-1970s. There was upward pressure on wages  as private sector unions represented a greater part of the work force and rising prices would be met by union pressure to raise wages. The  diminished power of the private sector unions has meant workers have settled for pay that has lagged inflation. (Public sector unions are another story, which will be covered  elsewhere.)

The FED has measured a threshold for a previous time in U.S. economic history, which will allow Chairperson Yellen to backtrack  on forward guidance by the new use of several qualitative measures. Thresholds have been shackles of Fed’s own design. How Ms. Yellen chooses to remove the shackles in an effort to stimulate wage growth will the challenge that awaits the new Fed chair. But the 2014 election is already raising issues about the heightened risks of wage inequality. This Fed will not undermine the administration’s effort to correct the great wage disparity of the previous three decades.

Link to blog post: February 13, 2014–Just a Song Before I Go (Graham Nash)

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7 Responses to “Notes From Underground: Why The Fed’s Forward Guidance Model is Flawed”

  1. Shocked to Find Gambling Says:

    Yra- Agree with what you said. Saw Ed Lazear on CNBC last night. He aid that employment has actually been weakening for the last 6 months, based on fewer total hours worked by the workforce.

    I think Yellen will latch onto any metric or non-metric she can to stay loose (and bikini sales were way down in Chicago in January).

    The FED is trying to keep the bubble going until the economy catches up with the markets. Either the economy will come up to meet the markets, or the markets will come down to meet the economy (I think).

  2. yra Says:

    Shocked–well said and perfectly point on

  3. Dustin L. Says:

    “Corporate profits as a percentage of GDP are at elevated levels because capital has been well rewarded from the effects of globalization while the massive increase in the global wage pool has kept downward pressure on wage rates in the developed world economies. Throw in the historical low borrowing rates set by the world’s central banks and the result is enhanced corporate profits.”

    Very well said sir! Add robotics and AI to the mix in this era of creative destruction and the Fed’s models face a serious problem of credibility and chronically questionable causality. Janet, it might be time to brush up on Hume’s An Enquiry Concerning Human Understanding, for is that actually casualty you are seeing or just the perception of it? Great piece Yra!

    P.S. There is enough going on right now in a macro sense to keep a person busy no doubt between transition at the Fed, China, EM markets, Ukraine, Venezuela, Middle East unrest, EU political fragility, etc. But, US equities keep marching higher, which is telling. It should be interesting to see what rates, the curve and the dollar do as the equities rally. US Equities are having a hard time breaking out in real terms. Breadth also becoming more important now at this stage. In the end we are all slaves to the tape. “A money managers job is not to forecast but to adapt.” And adapt we shall.

  4. Chicken Says:

    Immigration reform (on behalf of special interest groups) is wage deflationary?

  5. yra Says:

    Chicken–historically if the numbers are big enough but globalization has certainly changed that dynamic.Now the corporate world can cherry pick to fill its needs

    • Chicken Says:

      yra-agreed on the surface, and free trade agreements are perhaps the enabler for globalization which seems to me would tend to increase the standard of living in developing countries, leading to demand for nearly everything such as commodities, corporate produced goods and services, before factoring in phenomenon such as financial servitude, etc.?
      The complexity is staggering.

  6. Chicken Says:

    New high for SPX, global demand continues outstripping concerns? Perhaps women in India appreciate the long-awaited access to modern conveniences such as sanitary napkins, despite limitations men may continue imposing.

    My sort of way of simplifying the equation so it’s not so difficult for my consumption.

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