America's economy: A bumpier ride

Ben Bernanke's deft touch. Will it last?

The Economist
Jul 18th 2007

A YEAR ago, some in the financial markets had their doubts about Ben Bernanke. Inflation was rising and the boss of the Federal Reserve had fumbled his early communications with Wall Street. No longer. As Mr Bernanke heads to Congress on Wednesday July 18th to begin to deliver his twice-yearly monetary testimony, his competence will be lauded from all sides.

Nothing builds credibility quicker than success. And the Bernanke Fed seems to have got monetary policy right. Its decision, last August, to hold short-term interest rates at 5.25% has been vindicated. The policy of squeezing inflation out of the economy without crushing it seems to be paying off.

The Fed has got two big calls right; that the housing market would slow the economy but not derail the consumer enough to cause a recession; and that inflationary pressures would abate. But the economy has endured a bumpier ride than forecast. The homebuilding slump has proved deeper and longer than Fed officials had expected. Housing investment plummeted by 16.4% in the year to the first quarter, cutting a full percentage point off GDP growth.

Yet the Fed’s biggest concern is still that a tight labour market may prop up inflation. A puzzle is why unexpectedly weak growth failed to push up America’s jobless rate. The unemployment rate in June was 4.5%, down from 4.6% a year earlier and comfortably below the Fed’s predictions, last summer, of as much as 5%. But it is possible that employment is not as strong as it appears. The biggest surprise is how few jobs have been lost in home building. On some measures, activity in housing construction has slumped by more than a quarter since early 2006. Yet employment in the sector has fallen by less than 4%, or 140,000 people, from its peak. Economists at Deustche Bank suggest that 900,000 jobs might have been expected to go.

It is unlikely that builders are hoarding workers, with stocks of unsold homes still rising. A few workers may have shifted into non-residential work, building schools, shops and factories. That type of construction has held up well but the skills required are quite different.

Another possibility is that illegal immigrant workers, who do not show up on the books, are bearing the brunt of the losses. In a notoriously cyclical business, the use of temporary workers and undocumented immigrants is widespread. Legal Hispanic workers account for nearly 30% of employment in construction. Illegal Latino workers play a significant role too and, like legal temps, are most vulnerable during a downturn. By tracking the sensitivity of Hispanic employment to shifts in house-building activity, Deutsche Bank researchers conservatively estimate that there have been 500,000 job losses among such Latino workers since last year. If correct, this suggests a labour market less tight than it appears.

Another sign of a faltering jobs market is a decline in the share of the population that is willing to work. The labour-force participation rate is down 0.3 percentage points since December 2006. Normally, if the jobs market is strong, the participation rate increases. Jared Bernstein at the (union-backed) Economic Policy Institute points out that the participation rate has fallen particularly for groups that are often hurt first in a weak economy: since December it is down 0.6 percentage points for blacks and 0.9 percentage points for Latinos. Were these people included in the workforce, he reckons the jobless rate would be 5%.

A slacker labour market would help explain another puzzle: why wages have not accelerated faster. Average wages for non-supervisory workers rose by 3.9% in the year to June, compared with 4.3% in 2006. With unemployment at, or below, the level most economists associate with full employment, that seems odd. Pressure for higher wages is the inflation risk that most concerns America’s central bankers, but so far it has failed to materialise.

In fact inflation has slowed a bit sooner than hoped. In May core inflation—an index of personal consumption expenditures excluding food and energy—dipped below 2% for the first time in more than three years. Set against that, higher fuel and food costs have kept headline inflation up. Add in high energy prices, the weakening dollar and strong global growth and there are plenty of reasons why the Fed continues to worry more about inflation than growth.

But the balance of risks may be subtly shifting. There are concerns that American consumers may be faltering. Retail sales fell by 0.9% in June and recent profit warnings from Home Depot and Sears suggest that the effects of the housing slump may be spreading. For now, the central bank is rightly focused on the risk that inflation persists. But the economy may possibly be weaker than the Fed believes.