Fed Faces Rate Hike/Jobless Rate Dilemma

By Economic IndicatorsFOXBusiness

As the headline unemployment rate continues to fall for all the wrong reasons, the Federal Reserve faces an increasing dilemma over the timing for raising its key fed funds interest rate.

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A disappointing December jobs report released Friday revealed that, despite the economy adding just 74,000 jobs, far below analysts’ expectations, the U.S. unemployment rate dropped to 6.7% last month, down from 7% in November.

The jobless rate is now at its lowest level in five years, which, under different circumstances, might be cause for celebration.

But in December as in many recent months when the rate has fallen, the sharp reduction was primarily a result of hundreds of thousands of people (347,000 last month) leaving the workforce, partly out of frustration that they can’t find a job. The labor participation rate, which fell 0.2% month-over-month, now stands at 62.8%, its lowest level in nearly four decades.

The problem facing the Fed is that members of the policy setting Federal Open Market Committee have established a 6.5% unemployment rate as a threshold for when the Fed will consider raising the fed funds rate, the rate at which banks charge each other for overnight loans.

The thinking went that if the unemployment rate fell to 6.5% it meant the economy was healing nicely and that it was time to start raising interest rates to a more normal level. (The fed fund rate was dropped to an historic low of 0%-0.25% in December 2008 in the wake of the financial crisis.)

But what if the primary reason the unemployment rate is falling toward that threshold is not because hundreds of thousands of jobs are being created each month but rather because hundreds of thousands of Americans are leaving the workforce?

When people stop looking for work they are no longer counted by the government as part of the work force. That shrinks the ranks of workers counted as unemployed and pushes down the unemployment rate.

In any case, analysts said the Fed is unlikely to alter its time-frame for raising interest rates based on the December jobs report, which was undoubtedly impacted by bad weather last month in many areas of the U.S.

“It seems extremely unlikely they would alter the stance of policy based on one potentially messy report.  Especially in the context of the bulk of recent economic data coming in on the constructive side,” said Tom Porcelli, an economist at RBC Capital Markets.

In fact, the Fed may have inadvertently addressed this very dilemma last month when it announced it would begin scaling back its easy-money policies.

Citing improvements to U.S. labor markets that appeared to be showing consistent growth late last year, the Fed said it would begin tapering its bond purchase program known as quantitative easing in January. In an effort to quell fears that tapering might somehow be connected to the Fed’s timetable for raising interest rates, central bankers took pains to communicate that interest rates would remain at their low level “well past” the time at which the unemployment rate hits the 6.5% threshold.

The question, of course, is how long is ‘well past’?

Marc Chandler, a market strategist at Brown Brothers Harriman, echoed the view that the Fed is unlikely to base future policy decisions related to the unwinding of its long-running stimulus policies on any single piece of data or monthly report.

“Although the Fed clearly put more emphasis on the improvement in the labor market than in the low core inflation measures in last month’s decision to taper, its statements on the labor market seem to reflect a view of a cumulative improvement, not simply a one-month data point of a notoriously volatile report,” Chandler said.

In other words, the Fed has already given itself plenty of leeway in terms of the 6.5% unemployment threshold and the decision to raise the fed funds rate, which will have a much broader impact on the economy than an end to quantitative easing, will undoubtedly be based on many months of aggregate evidence that the economy is strong enough to start standing on its own.

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