Interest Rates and Jobs—the Fed Watches Unemployment

A job seeker fills out an application form at the Veterans On Wall Street job fair in New York. Photograph by Scott Eells/Bloomberg

As long as inflation remains in check, the Federal Reserve has promised not to raise interest rates until unemployment hits 6.5 percent. So how long until that happens? A few estimates are worth noting for the contradictions they reveal in the labor market.

According to calculations by the Brookings Institution’s Hamilton Project, at the current pace of job growth, about 155,000 jobs per month over the past two years, we won’t see 6.5 percent unemployment until 2018. That would mean a decade of zero percent interest rates. It has been four years since the Fed lowered rates to near zero. Imagine another six.

But don’t worry. Most economists think we’ll hit 6.5 percent way sooner than 2018. The average prediction of 75 economists surveyed by Bloomberg is that unemployment will be down to 7.3 percent by the second quarter of 2014. Both Joe Lavorgna, chief economist at Deutsche Bank, and Jacob Oubina, senior economist at RBC Capital Markets, think we’ll be at 6.5 percent by then. That’s not because they feel better about the economy. It’s actually because they’re more pessimistic about it.

The researchers at the Hamilton Project based their projections off the Congressional Budget Office’s 2011 estimates (PDF) of labor force participation over the next decade. The CBO assumes that for the next 10 years, the size of the work force will grow at the same pace it did over the previous decade, 0.8 percent a year. Right now, the labor force is expanding at less than half that pace. As people give up looking for a job, the labor force is growing much slower than anticipated.

The smaller the labor force, the fewer jobs you need to push down the unemployment rate. This is the dark cloud behind the steady decline in the jobless rate we’ve seen over the last year. Much of  the drop has been due to people fading from the labor force, rather than robust job gains. If you factor in the 2.5 million people who want a job but have stopped looking, and therefore aren’t counted as unemployed, the jobless rate jumps to 14.4 percent.

This the trouble with tying monetary policy to the unemployment rate: It’s murky as a signal for the health of the economy. James K. Galbraith, an economist at the University of Texas, thinks that continued shrinkage of the labor force will lower the rate faster than a strong economy that encourages people to start looking again. “A stronger economy might actually hold it up longer,” says Galbraith.

And that’s the irony of the current labor market. The slow pace of job growth has actually hastened the decline in the unemployment rate. Once the economy starts adding more jobs and people are compelled to restart their job search, the unemployment rate may stagnate, if not rise. This is what Jan Hatzius, chief economist at Goldman Sachs, thinks is going to happen in 2013. “I’m surprised at how quickly the participation rate declined this year,” says Hatzius. “Our models say it should stabilize, if not rise, next year.” Which is why he foresees a slowdown in the decline in the unemployment rate through 2013. Not because the economy will be worse off, but because it will be better.

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