The Jobs Report the Fed Should Be Waiting For

We're not done yet.

Photographer: Joe Raedle/Getty Images

With a pretty solid recovery now under way and the unemployment rate way down from its recession-era peak, the U.S. Federal Reserve is wondering when to start raising interest rates. It has said it will be "patient" -- which investors have taken to mean "not before the middle of this year." That might not be patient enough.

The timing of the first increase depends -- or ought to -- on the outlook for inflation. The Fed's calculation unavoidably involves guesswork, but here's one way to look at it: The Fed can choose to err on the side of a bit too much inflation, or a bit too much unemployment. In current circumstances, the first error is preferable.

The Fed's policy-making committee will aim to act early enough to keep inflation expectations in check, but not so early as to throttle the recovery. In striking this balance, the state of the labor market figures prominently. Once the recovery has taken up all the slack in the labor market, continued monetary stimulus will push wages higher, and inflationary pressure will build. So the question is, how much slack remains?

With unemployment at 5.7 percent, the answer might seem to be "not much." Most economists think that, in the U.S., an unemployment rate of roughly 5 percent is full employment. But the recent recession was unusually severe, and the labor market was stretched out of shape. The figures may not give an accurate reading of slack -- not good enough, anyway, to trigger higher rates without other signs of inflation.

The main problem is that the headline rate of unemployment excludes other measures of underemployment -- in effect, hidden labor-market slack. These worsened during the recession. At the end of last year, almost 9 million people were unemployed. Excluded from that number were 2.3 million more who wanted a job but hadn't "actively" looked for one in the previous month; also excluded were 6.8 million part-time workers who would have preferred to be working full time.

Full Employment

It's impossible to say exactly how much extra patience from the Fed this disguised unemployment should justify, but keep another point in mind. Inflation is currently running at less than the Fed's target of 2 percent, and the recent strength of the dollar will help to keep it there. A temporary modest undershooting of the target is no great cause for concern -- but the same goes for a temporary modest overshooting. Indeed, if the Fed interpreted its target as a ceiling, never to be exceeded, then over time inflation would average less than 2 percent. To hit the target over time, occasional small overshoots are actually necessary.

In short, there may be more slack in the labor market than the standard measure suggests, and there's some latitude on inflation as well. Rather than trying to anticipate higher inflation, as it might under normal circumstances, the Fed should wait until it sees the whites of its eyes. At the very least, it should wait until it sees either actual inflation or sufficient labor-market tightening to cause wages to rise significantly -- a trend that January's gain in hourly earnings, while welcome, does not yet constitute.

Patience is a virtue. And there's never been a better time for the Fed to be virtuous.

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