Jobs, triggers and the Fed

December 11, 2012

As Federal Reserve officials debate whether to use thresholds for inflation and joblessness to guide monetary policy, Friday’s jobs report may be a cautionary tale.  The idea of thresholds is to pick markers for potential policy change – an unemployment rate of 6.5 percent, for instance, as a guidepost for when the central bank might begin to raise rates – so that the market has a better idea of where Fed policy is headed. As the unemployment rate nears that level, the theory goes, investors will gradually start to price in tightening; if the unemployment rate rises again, they’ll price it out.

But some Fed officials, notably the hawkish heads of the Richmond, Philadelphia and Dallas regional Fed banks, oppose the idea. One reason: the unemployment rate alone cannot capture the state of the labor market. Friday’s report show why.

Unemployment in November fell to 7.7 percent, the lowest in nearly four years. But the decline was not a sign of labor market strength – far from it. People were giving up looking for jobs, signaling hopelessness, not hope.

If the Fed adopts thresholds, some worry, such a decline could perversely spur some market participants to price in a bit earlier tightening, exactly what the Fed wants to avoid.

Threshold advocates are well aware of this pitfall – and have sought to defuse it. Chicago Fed President Charles Evans, an early and vocal proponent of thresholds, has repeatedly said that a drop in the unemployment rate is not the only thing the Fed will look at, even if it does adopt a specific unemployment-rate threshold. Evans said he would also need to see above-trend GDP growth and at least six months of jobs gains of 200,000 or higher. By that measure, November’s report falls short, with only 146,000 new jobs.

Still, the significance of November’s report won’t be lost on Fed policymakers, who meet next week to debate not only thresholds but also whether to add to their existing asset-purchase program.

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