People will be parsing the minutes of the last FOMC meeting even further, given the disappointing 74,000 figure in the December jobs report (which dramatically undershot analysts’ expectations of between 200,000 and 250,000), the decline in the participation rate, and the stagnant situation for the longer-term unemployed. These incoming data points don’t square with the somewhat more positive tone reflected in the minutes of the FOMC’s early December meeting, undoubtedly influenced by the November jobs figure of 241,000. The jobs numbers mean that the task for the new FOMC has just become more challenging, because the decline in the unemployment rate to 6.7% is now strikingly close to the 6.5% target at which the FOMC stated it would begin to “consider” a change in its zero-interest-rate policy. Given that the unemployment rate dropped by 0.3 percentage points between November and December, hitting 6.5% could happen sooner than anticipated.
Now it is hard to claim that the drop in the unemployment rate means that the economy is out of the woods or that the labor market has recovered. The number of unemployed people still stands at 10.4 million, despite having declined by some 1.9 million during 2013. The participation rate also declined in December from 63% to 62.8%. There is continuing debate about whether the decline from historical highs in a non-war economy – 66.5% in 2003– is due to secular or structural issues. But it is clear, that the decline in the headline unemployment rate has resulted not from more people finding jobs but from more people leaving the labor force, for whatever reason.
Then there is the plight of the chronically unemployed. The number of long-term unemployed – those who have been actively seeking employment but have been unemployed for more than 27 weeks – was essentially constant at 3.1 million. Moreover, there is still a very large gap even among those who are employed part-time but who would like full-time work. Indeed, that number was stagnant at 7.8 million in December.
All the nuances in assessing the condition of the labor market will become even more important as the headline unemployment number declines further. However, we should not expect much movement on the part of the FOMC as far as backing away from its zero-interest-rate policy, even as the headline number approaches or breaches the 6.5% trigger. Indeed, these broader considerations were undoubtedly behind the urging of some FOMC participants, as revealed in the December FOMC minutes, to publicly drop the trigger to 6%. This also means that we should expect FOMC participant speeches in coming weeks to focus on these deeper indicators of labor market conditions, to waffle on the significance of the 6.5% trigger, and to emphasize that a wide range of incoming data will play a more important role than headline unemployment in decision making.
But labor market conditions are not the only relevant factor affecting the FOMC’s policy stance. Because of the Fed’s dual mandate, the inflation situation is also critical – and to some, more important than the employment objective. Up until the recent drop in the unemployment rate, there was no conflict between the Fed’s employment and inflation objectives. Unemployment was unacceptably high, and inflation was below target. An accommodative policy was supportive of both objectives. However, as the employment situation improves, the potential conflict between unintentionally over stimulating the labor market and moving the inflation rate up to the Fed’s 2% target may become a reality. Low inflation would call for more policy accommodation, whereas the employment situation might call for some tightening to avoid an overheating of the economy. However, historically there are long and variable lags between changes in policy and their impact on the economy. So keeping rates too low could lead to an undesired increase in inflation that significantly overshoots the target and requires strong action to reverse course. Think of this delicate task as analogous to trying to steer an aircraft carrier. Turn the rudder now and it may take some time before the ship responds. Turn it too far and the ship may overshoot the intended direction.
Ironically, this policy situation is the reverse of the typical goal conflicts the FOMC has faced historically. Usually, the problem has been an underperforming labor market and an undesirably high rate of inflation. In such times, the FOMC has tended to defer action to tighten policy in order to address inflation concerns for fear of harming the labor market and/or causing a recession. In either case, however, delays in taking policy actions can be disruptive to markets and the economy. Such policy conflicts are what have been on the minds of some FOMC participants, and they lie behind many of the recent policy dissents that have occurred.
Policy goal conflicts are likely to come into sharper focus in coming months as the economy and labor markets improve. But some fear that as long as inflation remains quiescent, the temptation for the FOMC to keep policy accommodative in an attempt to create even more jobs will be too strong and will lead the Committee to overshoot its goals. The temptation to wait will be especially strong for those who give greater weight to the FOMC’s employment goals and especially for the new chair and new appointees to the Federal Reserve Board. Their speeches, in particular, will likely emphasize why the unemployment rate is not totally reliable or the sole indicator of labor market conditions. They will also stress the importance of forward guidance and, as we saw during the unfolding of the tapering saga, the Committee’s determination to achieve both its employment and 2% inflation targets.
As for what this means for financial markets, many participants will focus primarily on the trajectory of the unemployment rate, a strategy that will likely lead them to anticipate a policy move long before it happens. Should future jobs data continue to disappoint – and because of the extreme weather in both the Northeast and Midwest, it is unlikely that the January numbers will be strong – the risk is that we could see a repeat of the experience of last June, when the Fed hinted that a tapering of its quantitative easing policy was near. Markets responded, and then because of its assessment of incoming data, the FOMC failed to deliver. Let us hope that the communications are clearer this time than they were last June.