In our recent quarterly video we argued that there is far less slack in the economy than the Fed seems to think. This is the first recovery since World War II where the output gap has narrowed because of downward revisions to potential GDP growth. The revisions to the potential GDP growth are largely a function of a steadily declining labor participation rate. Yesterday we learned that the economy grew at a 4% annualized rate in the second quarter, and today we learned that the employment cost index rose at a 3% annualized rate in the second quarter (chart below).
Combining these two pieces of data suggest that:
1) The economy grew faster than potential in the second quarter, thus sending labor costs higher, and
2) The participation rate has not stopped falling, and
3) The output gap is much closer to zero than the official estimates suggest.
The second and third points are important because Janet Yellen is engaging in a big gamble that a cyclically improving economy will elicit a supply side response, thus depressing the early signs of cost-push inflation. Today's ECI would seem to challenge the hypothesis that there remains a huge amount of slack in the labor markets.
If Yellen is wrong and the falling participation rate is a structural phenomenon, then the Fed will be forced to begin tightening monetary policy with the economy languishing at a 2% growth rate. Perhaps this scenario of the recovery running out of track is what sent stocks 2% lower today and volatility surging by almost 30%. This puts a huge amount of weight on the participation rate component of tomorrow's labor market report. If the participation continued to fall, it will be hard to ignore the appearance that the Fed is making a big mistake and may have to jerk the reins sooner than is currently expected.