Like it or not, the U.S. Federal Reserve will continue to focus on the unemployment rate under the new chair Janet Yellen – and bedevil investors, particularly those who believe the Fed is on auto pilot.
Shaking the auto pilot label will prove tricky for the central bank in the months ahead. The U.S. employment report last Friday gave decidedly mixed signals on the state of the economy and direction of monetary policy. The unemployment rate dropped to 6.6 per cent in January, edging ever-closer to the Fed’s supposed guidance target of 6.5 per cent, despite the weather-sodden addition of just 113,000 net new jobs in the month.
With the unemployment rate now edging close to the Fed’s longer-run goal, investors are starting to suspect the Fed is de-emphasizing the unemployment rate as a reliable indicator of labour market and economic health. A closer inspection of recent Fed communication suggests the unemployment rate target of 6.5 per cent may soften, but there is no indication that the metric is passing out of favour at the Fed.
Indeed, in a recent column in the Financial Times, outgoing Pimco chief executive officer Mohamed El-Erian suggested that the Fed’s pivot away from the unemployment rate in recent speeches and testimony, and toward a broader range of growth indicators, implies that the monthly jobs report will start to dim in importance to the Fed and investors alike.
There are at least two flaws with this argument. First, the monthly U.S. jobs figures have for decades held pride of place as the most market-moving economic report – and rightly so, since it provides the broadest and most timely information about economic conditions in the U.S. economy.
The other issue is that the unemployment rate has never been the primary focus of the Fed, either before the 2008 financial crisis or after. Under the Federal Reserve Act, the Fed has a triple mandate (not dual, as is commonly supposed): “To promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
Nonetheless, historically the Fed has expressed publicly the first of those three goals through the lens of the unemployment rate. Policy makers and politicians fell into this shorthand expression of labour market health about a century ago, with the first evidence of a modern-day concept of the unemployment rate emerging during the Great Depression in the 1930s, chronicled by noted labour market economist David Card of the University of California-Berkeley in a paper entitled “Origins of the Unemployment Rate: The Lasting Legacy of Measurement without Theory.”
According to Mr. Card, the unemployment rate has evolved into a metric grounded in economic theory.
As a reminder, the official unemployment rate is defined as the number of unemployed divided by the labour force. The labour force is the sum of people employed and unemployed, which in turn is a fraction of the working-age population. The controversy has always surrounded how to measure “unemployed.”
The concept of the unemployment rate has come a long way since the days when government workers would stand in a few local post offices and ask passersby whether they currently had a job. The modern-day definition of unemployment is grounded in search (or matching) theory, basically a supply-and-demand framework in which a potential worker is matched with an employer. Enumerators use an exhaustive list of questions basically designed to determine whether the non-working person is able, in terms of skills etc, to find employment. Those who fit the criteria, but do not have a job, are defined as unemployed.
Thus there is a strong argument to be made that the conventional unemployment rate is the best indicator of future wage and price trends, an important attribute for an indicator used as an input to monetary policy. Most wage and price models show that broader measures of unemployment do not provide any greater explanatory power for determining inflation beyond that of the conventional unemployment rate. And most policy makers within the Fed, including the new chair, believe that price stability should be the main objective of monetary policy, through which they can achieve the goal of maximum employment. The evolution of these views was chronicled exhaustively by St. Louis Fed staffer Daniel Thornton in 2012.
That is not to say that other measures of unemployment don’t matter from a broader policy perspective. High numbers of university-educated workers toiling in jobs requiring a paper hat or those needing full-time work but only getting part-time hours, or people who have given up looking altogether, speak of a deep malaise in the economy. These problems within the labour market are the reason policy makers have become concerned about growing income disparity. But these issues are the mandate of fiscal policy makers through job training, minimum wage changes, etc. – not the Federal Reserve.
Sheryl King is an independent macroeconomic strategist with more than 20 years experience in the international financial industry and central banking.
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