Will 5.9 Percent Unemployment Give the Hawks Reason to Raise Interest Rates?

The Federal Reserve building, Washington Photograph by Andrew Harrer/Bloomberg

Today’s announcement that the U.S. unemployment rate unexpectedly fell to 5.9 percent in September is good and bad. The good part is obvious. The bad part is that it could mean the labor market is tightening up more than it should at this stage in the economic recovery. That would give inflation hawks at the Federal Reserve a reason to start raising interest rates, possibly chilling growth.

Members of the Fed’s rate-setting Federal Open Market Committee think full employment is somewhere between 5 percent and 6 percent, according to the survey of the 17 members released last month. At 5.9 percent we’re already below the top end of what Fed rate-setters think is full employment—i.e., the lowest the unemployment rate can get before inflation begins to accelerate undesirably.

And don’t count on Fed Chair Janet Yellen to restrain the hawks if it appears that the economy is overheating. As I write in the Opening Remarks column of the latest issue of Bloomberg Businessweek, Yellen should be taken at her word when she vows, as she has many times, to be “data dependent” and raise interest rates as needed. Yellen has been a dove to date—meaning someone who worries more about unemployment than inflation—but that’s only because unemployment has been very high and inflation nowhere in sight. As that situation changes, so will Yellen’s position.

Tamping down the likelihood of a quick Fed reaction is that there’s little evidence of upward pressure on wages. Hourly earnings were unchanged in September. Still, “if payrolls continue to rise by 250,000 a month and the unemployment rate continues to fall, higher wage growth may not be needed to prompt the Fed to hike rates,” Paul Dales, senior U.S. economist at Capital Economics, wrote in a note to clients today.

The best part of the jobs report today is that the Bureau of Labor Statistics estimated U.S. employers added 248,000 jobs, which was more than the 215,000 median expectation of economists surveyed by Bloomberg. Also, job growth in August was revised upward to 180,000 from a weak 142,000, and July growth was revised up as well. It makes sense for the unemployment rate to fall a bit when job growth is strong. More people on U.S. payrolls is unquestionably a good thing. The trouble is that we’re approaching the Fed’s definition of full employment while there are still millions left on the sidelines. There are more than 7 million people involuntarily working part-time. The black unemployment rate is 11 percent.

The worst part of the report is that the labor force participation rate fell to 62.7 percent, the lowest since February 1978, from 62.8 percent in August. When labor force participation is low, it means more people are, say, retiring or going on disability than are entering the labor force out of school. There are fewer people available to work, which puts a limit on the economy’s ability to grow. The Fed has to put the brakes on growth at an earlier stage to prevent the economy from overheating.

A bit of arithmetic explains the problem. The unemployment rate is calculated as the share of people who are in the labor force, actively looking for work, but don’t have jobs. In this case, some people who used to be looking for work dropped out of the labor force, so they were no longer counted as unemployed. To be sure, the bigger reason for the drop in the unemployment rate was a sharp decline in the number of people who told the BLS they were unemployed. (Although reported together, the payroll figures and the unemployment figures are derived from separate surveys.)

The labor force participation rate soared from the 1960s through the 1990s as more women entered the workforce, but stalled out at the beginning of the new millennium and then fell sharply when the 2007-09 recession hit. It hasn’t recovered—and is actually drifting lower as more boomers retire.