The 6.5% Solution? Why the Unemployment Rate is an Unreliable Target for the Fed

The Federal Reserve Board is making a mistake by using the unemployment rate as a target for monetary policy.  I write this as a labor economist not an expert in monetary policy.  My criticism is not about whether the Federal Reserve should have a dual mandate.  Instead, I question whether the official unemployment rate is the best measure of labor market activity that Ben Bernanke and the Fed could use as their target.

Last week the Federal Reserve Board said that it would continue quantitative easing and keep interest rates low by purchasing $85 billion in Treasury securities per month at least until the official unemployment rate falls to 6.5%.  The Department of Labor reports six different measures of labor underutilization denoted U-1 through U-6.  The official unemployment rate, U-3, only include jobless workers who are willing and able to work and actively searched for a job in the past four weeks.  As Gary Becker noted on his blog, the unemployment rate is a flawed indicator of the state of the labor market because jobless workers may have become discouraged and stopped looking for work

Unemployment measures are sensitive to movements of jobless workers from the official category of “unemployed” to jobless and non-employed because they have, at least temporarily, stopped looking for work.  This means that the unemployment rate can fall for the wrong reasons; i.e. because unemployed workers gave up their job search and not because more people found jobs.  Consequently most labor economists use some variation of the employment to population ratio as a more robust measure of labor market activity.  At Welch Consulting we have constructed such an employment index that corrects for changes in the age distribution of the population and the difference between part-time and full-time employment.  The Fed should consider using a similar employment index as their labor market policy target.

For example, it appears that more than half of the decline in the unemployment rate in the past two and a half years, from 9.6% in May 2010 to 7.7% today, has been for the wrong reasons.  Since May 2010 the labor force participation rate has fallen from 64.9% to 63.6%; the adult population increased by 6.68 million and the labor force grew by only 1.08 million.  In other words there are 5.6 million more adults classified as “Not in the Labor Force” compared to May 2010.  Some of these adults are discouraged workers (and therefore counted in U-5 and U-6).  Others gave up looking for work more than twelve months ago and are not counted in any official Labor Department measure of underemployment.  Moreover, the employment to population ratio is 58.7% today, the same as it was in May 2010.  This means that in the past two and a half years employment has grown just in proportion to the adult population.

However, the official employment to population ratio reported by the BLS understates the gains in the labor market in the past 30 months for two reasons.  First, a higher percentage of jobs today are full-time than in May 2010.  Second, the aging of the workforce means that a larger fraction of adults are leaving the labor force for retirement.  The Welch Consulting Employment Index indicates that aggregate employment has grown about 1% faster than population after adjusting for the aging workforce and gains in full-time employment.  In contrast a decline in the unemployment rate from 9.6% to 7.7% over the past 30 months would have resulted in a 2.1% increase in employment had the labor force participation rate remained at its May 2010 level.  Consequently more than half of the apparent gain in the unemployment rate over the past 30 months is due to people leaving the labor force as they gave up their job search.

The last time the U.S. unemployment rate was 6.5% was October 2008.  Ben Bernanke has indicated that monetary policy could change once the unemployment rate drops to 6.5%.  Unfortunately, the difference between the health of the labor market today and in October 2008 is grossly understated by the 1.2% higher official unemployment rate today.  For example, the Welch Consulting Employment Index has declined by 4.25% since October 2008.  This means that in order to reach the same labor market activity as in the fall of 2008 full-time equivalent employment would have to increase by 4.25% (holding constant the adult population) and more than that as the population grows. Put simply the economy is short 6.1 million full-time jobs relative to October 2008.

The Fed does not expect the unemployment rate to decline to 6.5% until the end of 2015.  But changes in fiscal policy could cause the unemployment rate to drop rather suddenly, not because people find jobs, but because the long-term unemployed may stop looking for work.  What could cause this change?  Congress and the President could curtail the EUC2008 extended unemployment insurance program which allows unemployed workers to continue collecting unemployment insurance benefits for up to 99 weeks (in some states and some cases).  Typical benefits expire after 26 weeks, but the EUC2008 program has extended benefits for many jobless workers for at least 78 weeks over the past four years.  Currently about 2.2 million long-term unemployed workers collect EUC2008 benefits.  If these benefits are curtailed and 2 million of these jobless workers stop looking for work, the unemployment rate would immediately fall to 6.5%.

It is unlikely that all recipients of extended benefits will stop looking for work immediately after their EUC2008 benefits expire.  But once active job search is no longer a prerequisite for collecting benefits many unemployed workers will curtail their search, leave the labor force and lower the unemployment rate.  Once the EUC2008 program ends, it is quite conceivable that the unemployment rate will decline to 6.5% within a year despite a very weak labor market for many workers.

I leave it to macroeconomists and monetary economists to debate whether more quantitative easing can help stimulate real output and employment growth.  However, the Fed is wrong to link monetary policy to an unemployment rate that can increase when the labor market improves (and people resume their job search) and decrease when the labor market weakens (and people give up their job search).  Looking ahead it is more important how the economy reaches a 6.5% unemployment rate rather than the rate target itself.  The Fed’s policy guidance would be easier to comprehend if a better target was used for labor market activity.  A properly constructed employment index, that accounts for the changing demographics of the workforce, provides a much more accurate measure of the labor market’s strength.

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