Friday's miserable jobs report was written off as an anomaly: It was the weather. It wasn't consistent with other much stronger data over the past few months. It was so terrible that no one believed it to be true. I never understood this obvious hindsight conclusion. If it was so obvious, then why wasn't it reflected in economists' estimates?
What can't be denied is the growth rate in average hourly earnings. The December 2013 1.8% YoY growth rate decelerated from the November rate of 2.0% and was barely above the recovery trough growth rate of 1.6%. This is the most important of the employment metrics. Wage growth is the fuel for consumption growth, which is the fuel for aggregate demand, which is the Fed’s primary stimulative objective.
Average Hourly Earnings YoY Growth Rate
Incoming Fed chair Janet Yellen is a big proponent of stimulating aggregate demand in order to achieve the Fed’s employment mandate. In a March 4, 2013 speech titled Challenges Confronting Monetary Policy
in which Ms. Yellen outlines her monetary playbook, it’s clear she believes the main objective of forward guidance and asset purchases is to stimulate consumption:
The purpose of the new asset purchase program is to foster a stronger economic recovery, or, put differently, to help the economy attain “escape velocity.” By lowering longer-term interest rates, these asset purchases are expected to spur spending, particularly on interest-sensitive purchases such as homes, cars, and other consumer durables.
I see the currently available evidence as suggesting that our asset purchases have been reasonably efficacious in stimulating spending. There is considerable evidence that these purchases have eased financial conditions, and so have presumably increased interest-sensitive spending.
Translation: In order to create jobs, we are trying to induce consumers to spend money they don’t have on stuff they don’t need.
Financed consumption manifests itself in the retail sector, and it was retail employment that dominated the payroll number with 55,000, or 74%, of the 74,000 total hired. These are not the highly skilled jobs that produce wage gains, so it’s no wonder this retail-dominated employment report produced some of the weakest wage growth of the recovery. This report may have been an anomaly on job growth, but it was anything but in terms of wage growth. Since 2009 wage growth as averaged 2.1%; this is barely above the rate of inflation over the same period. Is this really the objective of monetary policy -- to stimulate jobs that produce no real wage growth?
Average Hourly Earnings YoY Growth Vs. PCE YoY Growth
To be fair, consumption -- which is the primary determinant of nominal GDP -- is showing more robust growth in recent months after hitting recovery lows in the first half of 2013, however it’s important to note that, since the crisis, consumption growth and wage growth have been converging. In fact, the largest post-crisis growth rates in consumption in 2011 coincided with the largest growth rates in inflation that produced negative wages that crippled the consumer. This is no way to stimulate an economy.
Stimulating financed consumption with negative interest rates that's serviced with flat wage growth is not a sustainable strategy, and one conclusion I took from Friday is that the economy looks to be much more sensitive to interest rates than what many assume. There is a prevailing assumption by both market participants and policymakers that interest rates are lower than they otherwise would be absent QE. Even on Friday, bond king Bill Gross stated that 10-year yields were 100bps lower than they would be if the Fed weren’t buying bonds. Is it a coincidence then that the two weakest employment months of the year, July and December, both occurred after large spikes in long-term interest rates?
What’s important to keep in mind about the rise in rates is that forward guidance and QE affect long-term interest rates, not by the flow of purchases, but by the rising inflation discount that lowers real interest rates. It is the inflation premium embedded in the nominal rate that produces the real interest rate that has been governing bond yields under QE. When the Fed floated the taper idea in the spring, thus not defending the inflation target, the Fed unlocked the long end of the curve, which then began to price in lower inflation premiums and higher real rates. Since then the bond market has been seeking to find equilibrium, and each time the 10-year has approached 3.0% we've seen an economic reaction. Is equilibrium below 3.0%?
The story for 2014 could be about how much aggregate demand the Fed pulled forward by stimulating financed consumption and whether demand growth is sustainable at higher rates. In the housing market, which is no doubt the most interest-sensitive expenditure, there has been no doubting the reaction to higher rates. Mortgage applications for both refinance and purchase loans have both declined significantly since interest rates lifted in 2013. The following is from Friday’s Wall Street Journal:
The Mortgage Bankers Association next week plans to cut its 2014 forecast for loan originations, which include loans for home purchases and refinancing. The current forecast of $1.2 trillion would represent the lowest level in 14 years. The trade group Wednesday reported that mortgage applications in the two weeks ending Jan. 3 touched a 13-year low.
MBA Mortgage Applications
Now, refinancing is evaporating, said David Stevens, CEO of the Mortgage Bankers Association, and "the business is completely shifting" toward home-purchase lending as rates rise.
With refinances encompassing two-thirds of all mortgage volume, investors are going to see a significant decline in total supply. Even with the Fed tapering purchases, the pace of reduction is slower than the pace of the decline in new mortgage origination; thus, as the Fed tries to reduce stimulus, it is still buying a larger percent of overall volume. In fact whether the Fed is buying or not, it’s not clear there is any meaningful increase in mortgage demand at higher rates. This is likely due to the fact that housing demand is ultimately a function of employment growth but more importantly, wage growth. With purchase demand becoming a larger percentage of total mortgage supply, rising mortgage rates are going to require an increase in wage growth.
Wage growth has failed to sustain any acceleration during this recovery and remains barely above the rate of inflation, which is far below the Fed’s target. In fact, the closer the Fed gets to its inflation target the lower real wage growth becomes. Currently, growth in aggregate demand -- which is subsidized by negative interest rates -- exceeds wage growth, but this is not likely sustainable in a rising-rate environment.
In theory, rising rates should be a function of increasing aggregate demand, which would no doubt be a function of rising wages. However, with wages stagnating, aggregate demand seems to be highly sensitive to higher interest rates because it is all leveraged. Thus, as rates seek equilibrium, growth in aggregate demand should be more a function of wage growth, which will ultimately price the cost of capital.
Interest rates, like any commodity, are self-correcting, and the bond market is seeking equilibrium. With the Fed backing out of the market, investors are trying to determine what rate of interest equilibrium is achieved to optimize the cost of capital relative to aggregate demand. It’s quite possible this has already been exceeded, and if so, interest rates are poised to decline despite the Fed’s reduced participation.