Asset Allocation Bi-Weekly June 27, 2022


Politics is the art of the possible…
—Otto Von Bismarck

Although there have been attempts to treat it as a science (hence the study of political science), the necessary art of politics is to convince people to accept policies that may be contrary to their best interest. This quote succinctly sums up the problem.

We all know what to do, but we don’t know how to get re-elected once we’ve done it.
—Jean-Claude Juncker

Political stocks are sold. Simply telling the public that a tough policy mix is ​​needed doesn’t work very well. So decision-makers create stories to justify and explain why something difficult won’t be so bad or affect anyone you know. For example, higher taxes for higher income households are presented as “paying your fair share”. Windfall taxes are there to “share the pain”.

The Federal Reserve faces a similar problem. Simply stating that the policy needs to be strengthened is unpopular. Thus, major policy changes must be formulated in a way that the public will accept. Alan Greenspan realized that monetary policy could reduce stock prices; in 1996, he implied, with the term “irrational exuberance,” that stock prices were too high relative to earnings. The backfire was bad enough that he never talked about it again. The Federal Reserve’s policy on this is that market bubbles cannot be determined in real time, and if they do occur, it is easier to undo the damage afterwards(1).

Another example is Paul Volcker’s move to money supply targeting instead of interest rate targeting. Money supply targeting has allowed the Fed to raise rates to unprecedented levels. Aiming for a federal funds rate of 19.1% (for the record, in June 1981) would have been politically impossible. But making this rate happen “naturally” by limiting the money supply led to the necessary result in a politically possible way.

We may see Powell’s Fed attempting something similar. Although the Philips curve has been largely disavowed by the Fed, in reality the spirit of the relationship remains; to contain inflation, the Fed must slow the economy enough to create slack in the economy. In simple terms, this means the Fed must create unemployment to bring inflation down. Even under conditions of low unemployment, such a policy is politically unacceptable.

Thus, President Powell and Governor Waller suggested that instead of increasing unemployment, it might be possible to reduce the “foam” in labor markets by decreasing the number of job openings. This idea is related to a concept called the “Beveridge curve”.

The Beveridge curve examines the relationship between job vacancies and unemployment. This curve attempts to show the efficiency between job openings and the filling of those openings. In general, moving away from the origin suggests less efficiency. The slope of the curve is also important. A flatter slope suggests greater efficiency because it takes relatively fewer job vacancies to reduce unemployment. We created curves for the last four business cycles, starting in 1994. After the 2001 recession, labor market efficiency improved as the curve approached the origin. However, the slope has steepened. In the expansion from 2009 to 2020, efficiency dropped. This was partially offset by a flatter slope.

The dots in the box indicate the end of the last extension. Note how the slope has essentially steepened. As job openings increased, it became more difficult to fill them. And then the pandemic hit. The current curve has steepened dramatically; the most recent data point is indicated by an arrow. Essentially, Powell/Waller’s position is that wage pressures could ease if the openings fall back on the slope of the green line from 2020 to early 2021. In other words, we could see the slack develop without a significant increase in the unemployment rate. Waller argues that if hiring efficiency improves, we might be able to ease inflationary pressures without a recession.

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This chart is another way to view data. It measures the number of unemployed against the number of job vacancies. It should be noted that from 2018 to 2020, the openings briefly exceeded the unemployed; at this point the slope of the Beveridge curve began to steepen. Pre-pandemic, the difference between the chart above and non-supervisory worker wage growth shows a positive correlation of +70% with the difference driving wage growth by about a year. Thus, if job openings decline, over time, this should ease wage pressures.

However, the pandemic has somewhat upset the labor market. This event led to an increase in the number of older workers leaving the labor market; so far, solid wages have not been enough to bring them back into the labor market. It seems more likely that the reduction in job vacancies will probably require some increase in unemployment. But by focusing on job vacancies instead of increasing unemployment, the FOMC can buy some degree of policy coverage to weaken the labor market.

(1) This is similar to Bob Uecker’s advice on how to catch a knuckleball… “wait until it stops rolling and choose
it’s rising.

Past performance is not indicative of future results. The information provided in this report is for educational and illustrative purposes only and should not be construed as individualized investment advice or a recommendation. The investment or strategy discussed may not be suitable for all investors. Investors should make their own decisions based on their specific investment objectives and financial situation. The opinions expressed are current as of the date indicated and are subject to change.

This report was prepared by Confluence Investment Management SARL and reflects the current opinion of the authors. It is based on sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change. This is not a solicitation or an offer to buy or sell securities.


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