The unemployment rate has fallen to 6.7 percent. January’s employment situation, to be released next Friday, may show an unemployment rate of 6 1/2 percent or lower—the Federal Reserve’s stated threshold for raising short-term interest rates. What does
this mean for the Federal Reserve, and for the economy's future?
In a previous article for e21, Charles Calomiris and I discuss reasons why the Federal Reserve ought to be wary about setting specific, numerical objectives for unemployment in the same way it has already set a specific, two-percent target for long-run inflation. It is not that Federal Reserve policymakers should not care about unemployment—to the contrary, they should. Nor is it that Federal Reserve policy cannot influence unemployment—to the contrary, it does. Rather, unlike inflation, which is in the long run determined exclusively by monetary policy, the unemployment rate is buffeted in both the short-term and long-run by a wide variety of factors beyond the Fed’s control to make that number a reliable guide for monetary policy.
As if on cue to prove this very point, the most recent statistics on the U.S. unemployment rate have interacted with language from the Federal Reserve’s own policy statements to provide yet another example of the difficulties and confusion that can all too easily arise when the central bank allows its decisions to be guided too strongly by labor market data. Since December 2012, the Federal Open Market Committee (FOMC) has provided “forward guidance” to the public about the future trajectory of its federal funds rate target, indicating that it intends to keep that short-term interest rate exceptionally low “so long as the unemployment rate remains above 6 1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s two percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”
The problem with these words is illustrated by the figures below, which show that since late 2012, the U.S. unemployment rate has fallen considerably, from 7.9 to 6.7 percent, and now stands very close to the FOMC’s stated numerical target. If one were to take the Fed at its word and the statistics at face value, one would have to conclude that the Fed’s goals for lower unemployment have been almost entirely achieved. Except, as the figures below also reveal, the employment ratio—defined as the percentage of the adult population who are actually employed—has not risen at all during the last year and, as a matter of fact, has not recovered any of the ground lost during the 2008-09 recession. How can this be?
Mechanically, the unemployment rate (expressed as a fraction instead of a percent), equals one minus the employment ratio divided by the labor force participation rate (also expressed as fractions). For the algebraically-inclined, the unemployment rate (ur) equals U/(U+E), where U is the number of unemployed workers and E the number of people who have jobs, the employment ratio (er) equals E/P, where P is the total adult population, and the labor force participation rate (lfp) equals (U+E)/P, so that ur equals 1 – er/lfp. In the abstract, this just means that when the unemployment rate falls, it can be because the employment ratio rises, the labor force participation rate falls, or a combination of those two. But what the figures below show is that, in fact, the decline in the unemployment rate from its peak in 2009 is due in its entirety to a decline in the labor force participation rate, a trend that began before, but accelerated noticeably during, the Great Recession and that is still quite far from being well-understood.
Of course, no one would suggest that the Fed should tighten monetary policy because the labor force participation rate is falling. But that is just the point. Having stated a specific 6 1/2 percent target for unemployment, the FOMC will now have to explain why it is necessary to move that target to an even lower level, potentially causing exactly the sort of confusion and uncertainty among the public that forward guidance was intended to prevent.
A much better course of action would be to remove specific numbers and language about the unemployment rate entirely from the FOMC’s policy statements. It is sufficient, at present, to simply observe that the incoming data on the whole continue to paint a picture of a recovery for the U.S. economy that is gradually picking up strength, and to note that, more importantly, the Fed’s own forecasts show inflation returning gradually to its two percent long-run target. Those points, alone, provide ample support for the FOMC’s recent decisions to scale back their massive bond-buying programs, in anticipation of the day when, eventually, the workings of monetary policy will return to normal.
The figures below, however, also serve to remind us that while considerable progress has already been made, and while there is good reason to believe that even better times lie ahead, the recovery remains fragile in many ways. Those FOMC members who urge caution, so as not to scale back too quickly, are well justified in their views. But, to make the case for caution, it is not necessary to make specific reference to a numerical target for unemployment. It is enough to point out that inflation has come in consistently below the two percent target since 2008. That sluggishness in inflation itself suggests that insufficiently accommodative monetary policy has partly responsible for the slow recovery and that it would be a mistake to tighten too much, too soon.
The Recent Behavior of Key Labor Market Variables
The recent decline in the unemployment rate reflects a decline in labor force participation; the fraction of the population with jobs has not recovered.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee. This commentary draws on a more detailed position paper being prepared for the March 14 SOMC meeting in New York, sponsored by e21 and the Manhattan Institute. He would like to thank Nathan McCune and Harold Petersen for conversations that helped sharpen his views on these issues, while emphasizing that he alone retains full responsibility for any errors or omissions that remain.