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Staying ahead of the Fed

She stands only 5ft 3in tall and yet a major financial publication recently described Federal Reserve chairwoman Janet Yellen as the “the one policymaker that towers above all others”. With the US dollar pushing new highs and the Fed inching closer to raising domestic interest rates for the first time in six years, Yellen's every move, or more importantly, every word is being carefully watched.

Most economists believe the Fed will raise interest rates sometime this year, although experts are heatedly debating exactly when this will occur. A few think the summer will see the initial bump but most bets are for later in the fall. Of course, even Yellen and the rest of the Fed do not know the answer for sure as the policy committee insists a forthcoming increase will be “data dependent.”

For example, recently professional traders moved their bets to a September hike as more likely after last month's jobs report came in on the light side. Softer employment suggests a delay, but that was just one data point.

Two key factors the under the Fed microscope are employment and inflation. Thanks in part to the plunge in energy prices combined with a soaring greenback, inflation remains tame by most measures. So with inflation trending below the Fed's acceptable level of 2 per cent, employment has become the key issue.

As of the latest US Labor Department report for March, America's unemployment rate has fallen to 5.5 per cent. Viewed solely within its historical context, the 5.5 per cent rate would normally be considered very close to “full employment”. This level has generally been considered a reasonable benchmark as even in the best of times some citizens will inevitably still find themselves in the midst of a job search.

Interestingly, when Ben Bernanke ran the Fed last term, his definition of full employment was a bit different. In December 2012, Bernanke reiterated the Fed's pledge to keep interest rates low “at least as long as the unemployment rate remains above 6.5 per cent”. That statement indicated a flat 6.5 per cent rate would be considered full employment and the point at which the Fed would like begin to remove monetary stimulus. However, later in June of 2013 Bernanke called the 6.5 per cent target a “threshold and not a trigger”. Of course, now the Yellen Fed has moved the goalpost even further down the field and the new leadership is clearly intent on prodding America towards a new definition.

One reason the Fed is not acting more aggressively on rates is the agency's consideration of other employment measures besides the absolute unemployment rate number. The Yellen Fed has clearly shifted its attention away from the ‘headline' number and is more seriously considering other employment statistics including wage growth, full time versus part time workers and total labour force participation.

Wage growth over the past several years has been decidedly low relative to inflation. In the latest employment report, for example, average hourly earnings increased by just 2 per cent, roughly in line with inflation. This means that after adjusting for higher costs, wages have basically been flat. Prior to the Great Recession in 2008, wage growth had averaged around three or four per cent but since then there appears to have been no real growth in wages which would benefit the average worker after accounting for the higher prices of goods and services.

Perhaps the most striking phenomenon in the current labour market is the divergence between the ostensibly optimistic unemployment rate, showing its best reading in seven years while the labour force participation rate (higher is better) sits at a 37-year low. How can the employment situation look so positive based upon one measure, while another statistic paints the situation as quite awful?

The answer is lies in the denominator or divisor of each statistic. The unemployment rate calculates the percentage of unemployed from the pool of the those able and looking for work, while the labour force participation rate simply calculates the number of employed persons across the entire universe of those able to work.

Since the credit collapse in 2008, a large number of potential workers dropped out of the pool of those looking for work. So-called ‘discouraged workers' are therefore not counted in the unemployment rate denominator, likely masking a much higher percentage of unemployed than appears in the headline statistic. Also, changing demographics such as the ‘baby boomers' retiring early affect the mix.

And finally, part-time workers are a concern. Surveys show a large number of people are working part-time jobs but would prefer full time employment. Even though these workers have just part time jobs, they are counted as employed. Part time jobs generally pay lower and do not offer the usual health and retirement benefits often given to full time employees.

As global markets bounce around this year, often in response to central bank monetary policies, comprehending the fundamental underpinnings these policies is important. Successful investors will dig deeper into the OECD employment reports looking beyond the headline numbers. Measures such as ‘U6', which includes underemployment, full-time versus part time job growth and aggregate wage gains will play a key role in setting government policies in the months ahead.

Bryan Dooley, CFA is a senior portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information.

This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.

Woman of influence: Janet Yellen, chairwoman of the US Federal Reserve

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Published April 21, 2015 at 9:00 am (Updated April 20, 2015 at 3:46 pm)

Staying ahead of the Fed

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