Nonfarm Employment, Inflationary Expectations, and Monetary Policy after the Global Financial Crisis

Author Name Willem THORBECKE (Senior Fellow, RIETI)
Research Project East Asian Production Networks, Trade, Exchange Rates, and Global Imbalances
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This Non Technical Summary does not constitute part of the above-captioned Discussion Paper but has been prepared for the purpose of providing a bold outline of the paper, based on findings from the analysis for the paper and focusing primarily on their implications for policy. For details of the analysis, read the captioned Discussion Paper. Views expressed in this Non Technical Summary are solely those of the individual author(s), and do not necessarily represent the views of the Research Institute of Economy, Trade and Industry (RIETI).

Macroeconomy and Low Birthrate/Aging Population (FY2016-FY2019)
East Asian Production Networks, Trade, Exchange Rates, and Global Imbalances

Will a tight labor market in the U.S. stoke inflation? How will the Federal Reserve respond to labor market pressure? As unemployment has fallen from 10 percent in October 2009 to 3.7 percent in September 2018, these questions have come to the fore.

Unemployment in the U.S. of 3.4 percent in 1968 and 1969 was followed by accelerating inflation that devastated the bond market (see Figure). On the other hand, unemployment in the U.S. that fell to 4 percent or less between 1996 and 2000 did not lead to inflation but instead contributed to productivity increases of 2.8 percent per year by pulling many into the labor force and providing them with on-the-job training. Is the low unemployment after the Global Fconomic Crisis (GFC) presaging a rise in inflation or an economic boom without overheating?

To address these questions this paper investigates how financial markets have processed news of rising employment after the GFC. Did they expect it to lead to higher inflation? Did they believe that the Fed would fall behind the curve and allow inflation to rise? Did they anticipate that the Fed would tighten too much and depress growth?

On the first Friday of the month the U.S. Bureau of Labor Statistics (BLS) announces the change in nonfarm employment (NFE) for the previous month. This announcement is closely watched by the Fed and by financial markets. Bloomberg surveys market participants to learn their forecasts for the NFE announcement. This study adopts the median forecast from the Bloomberg survey as the measure for the previously expected value for the announcement.

The paper investigates how NFE news affects the whole term structure of interest rates on U.S. Treasury securities (from four-week to 30-year) using daily interest rate changes. It also examines how employment news affects real interest rates and expected inflation by comparing yields on ordinary Treasury securities and Treasury inflation-protected securities (TIPS). The difference between these yields is called the breakeven rate and is the most common measure of longer-term inflation expectations.

The model regresses daily changes in interest rates, TIPS rates, breakeven rates, the log of stock prices, or the log of exchange rates on news about NFE:

where Δit is the change in the interest rate, TIPS rate, breakeven rate, or other variable over the 24-hours bracketing the announcement, NFEt is the announcement from the BLS at date t about nonfarm payroll employment in the previous month, and Et-1(NFEt) is the previously expected value of NFE from the Bloomberg survey.

Unexpected increases in NFE increase both the real interest rate and the breakeven rate, but the effect is twice as large on the TIPS rate as on the breakeven rate. This indicates that the real interest rate increases by more than expected inflation. It also has a small impact on the spread between the 1-year and 6-month Treasury interest rate and the largest impact on the spread between the 2-year and 1-year rate. The impact remains large for the 3-year minus 2-year and 5-year minus 3-year spread. There is no effect on the 7-year minus 5-year spread. This implies that investors expect positive NFE shocks to increase interest rates between one and five years in the future.

The sample period here differs from previous episodes because the Federal Reserve's policy instrument, the federal funds rate (FFR), was close to zero for several years. It seems likely that the real interest rate responses more than one year ahead reflect anticipations that positive NFE shocks will cause the Fed to raise interest rates once the Fed starts lifting rates again. To test whether the interest rate responses reflect anticipated monetary policy, the FFR can be interacted with NFE news. When the FFR was close to zero, investors would have expected a response in the more distant future. After "liftoff," when the FFR started increasing, they would expect less of an effect in the distant future. If this is true, when NFE*FFR is included in equation (1) the coefficient should be negative.

The coefficient on NFE*FFR is negative for all parts of the term structure from the 3-month minus 4-week spread to the 5-year minus 3-year spread. This indicates that when the federal funds rate was low, investors expected positive innovations in NFE to raise interest rates in the future. The effect is by far the largest for the 2-year minus 1-year spread. Evidence that the real interest rate is increasing comes from the TIPS rate and the breakeven rate. The coefficient on NFE*FFR is negative and significant for the TIPS rate but insignificant for the breakeven rate. Thus when the FFR was low, investors expected positive innovations in NFE to cause the Fed to tighten in the future and raise real interest rates.

What can we learn about how investors expect future Fed policy to affect the economy? The finding that NFE*FFR does not affect the breakeven rate implies that investors do not expect the future tightening to impact inflation. Thus they do not expect the future tightening to have a disinflationary effect. This indicates that they do not expect the Fed to overreact to an expanding economy. Since higher real interest rates in the future will decrease spending, the insignificant coefficient on NFE*FFR in the breakeven regression implies that the slope of the Phillips Curve relating inflation to unemployment is small.

Fed Chairman Powell (2018) said that the Federal Open Market Committee had to navigate between the shoals of overheating and premature tightening. The results in this paper indicate that they are doing well after the GFC. However, complacency is not warranted. The U.S. is imposing tariffs that will restrict aggregate supply and raise prices. U.S. budget deficits exceeding a trillion dollars per year will stoke aggregate demand. If inflation accelerates and inflationary expectations risk becoming unanchored, the Fed will need to act aggressively to maintain its hard-earned credibility.

Figure: Unemployment and Inflation Rate in the U.S., 1960 to 2018.
Figure: Unemployment and Inflation Rate in the U.S., 1960 to 2018.
Source: Federal Reserve Bank of St. Louis FRED database.