Jobs news was resoundingly disappointing in both Ottawa and Washington on Friday. But the U.S. report was the stuff that central bankers' nightmares are made of.
The U.S. economy generated just 74,000 jobs in December, much lower than the expected gain of 200,000. Economists are scrambling to explain this away – bad weather and the expiry of emergency unemployment benefits are a few of the distortions being emphasized.
One sluggish month is not so bad, and quite characteristic of the statistically-noisy data. This alone won't sound the alarms within the Federal Reserve.
More surprisingly, and disturbingly, however, the unemployment rate fell 0.3 per cent to 6.7 per cent. This sounds like good news. In fact, not only is it a bad sign for out-of-work Americans, it also indicates the growing unreliability of the unemployment rate as an indicator of the jobs market – and the Fed's policy framework, which is partly tied to it.
To the chagrin of economists who expected no change in the unemployment rate, the headline figure dropped because a growing number of Americans are giving up on finding a job. The U.S. labour participation rate, a metric economists have been nagging about for months, fell to 62.8 per cent, its lowest point since 1978.
The U.S. unemployment rate is arguably the most important data point in the world, because of its role in monetary policy. The Federal Reserve's quantitative easing program has distorted financial markets around the world, and global interest rates ebb and flow based on the outlook for the U.S. economy.
The problem is, the Fed's forward guidance framework specifies that the Fed will keep rates at zero, so long as the unemployment rate is above 6.5 per cent and inflation is below 2.5 per cent.
A 6.7 per cent unemployment rate is now dangerously close to this threshold, effectively becoming a red herring to Fed policy. Worse yet, forecasters expect the unemployment rate to continue to drop as we feel the effects of expiring emergency unemployment insurance benefits, perhaps dropping as low as 5.9 per cent in the coming months. Meanwhile, FOMC members anticipate raising interest rates in 2015.
It's abundantly obvious that the U.S. economy is not strong enough for the Fed to be raising interest rates right now, which leaves Janet Yellen in a bind. She has to explain to markets that the Fed will maintain an easy monetary environment for another two years, despite the Fed's stated policy threshold saying it's time for them to do the opposite.
Fed members are all too aware of this threat to the central bank's credibility. In last month's statement, they adjusted the forward guidance language to emphasize that the Fed will keep rates low "well past" the time that the unemployment rate reaches 6.5 per cent. But maintaining a policy signal that needs to be ignored is counter-productive.
Today's jobs report is the Fed's biggest wake-up call yet. At this point, Ms. Yellen's best option is to abandon the threshold altogether. Markets will test the Fed's resolve with each new piece of data, and there's no room for sending mixed signals.