We learned last Friday that in September the unemployment rate fell below 6 percent. This is, of course, good news. But "irrational exuberance" — to quote a former Federal Reserve chair — over the unemployment rate's rapid decline may undermine the very recovery the Fed is trying to push forward. How so? By giving additional credence to the argument that the Fed should raise interest rates sooner and faster. It shouldn't.
First, some background. It is something of a puzzle that the unemployment rate has dropped by over four percentage points from its Great Recession high while wage growth has been flat.
Imagine that you are an employer in an economy with high unemployment. It is easy for you to find workers since so many workers are unemployed and want jobs. You aren't facing a lot of pressure to pay more this year than you did last year, so you don't. (And your workers are in a weak position to bargain for higher wages, since the boss knows that if they quit it will be tough for them to find a new job.) Now imagine that the labor market is tightening — the unemployment rate is dropping; folks are finding jobs. All of the sudden you have to try a little harder to attract workers to your firm. You will likely decide to pay more this year than you did last year because you have to be more competitive. Unemployment goes down; wage growth goes up.
This sounds like common sense, and it is what we teach undergraduates. But our experience over the last several years suggests that we may be wrong. Even though the unemployment rate is falling, wages aren't growing. Time to go back to the drawing board?
Not so fast, say some economists and policymakers. If you look over the last three decades or so, when the unemployment rate falls below 6 percent wage growth tends to accelerate, as Dallas Fed President Richard Fisher recently argued. So while it's true that falling unemployment hasn't yet triggered increasing wage growth, the key word in that sentence is yet. And their (very reasonable) fear is that if wages start to take off we will see a broad-based acceleration in the prices of goods and services — rising inflation. Too-rapid inflation can be bad for the economy for a number of reasons, and once the inflation genie is out of the bottle it can be painful to shove it back in.
Ergo, says this line of thought, now that the unemployment rate is below 6 percent and may continue to fall, the Fed needs to raise interest rates sooner and faster than is typically expected.
This is not an unreasonable view — all sides in this debate need to acknowledge that it's impossible to predict with certainty the proper course of monetary policy. Some economists, such as Harvard professor Martin Feldstein, believe that 2015 may bring an increase in inflation, and all mainstream economists agree that the Fed needs everyone to believe that it will keep prices growing at a predictable and steady rate.
Ultimately, though, the Fed should be patient. It shouldn't rush to raise interest rates despite the relatively low and falling unemployment rate.
If the Fed increases interest rates too early and swiftly then the economy will cool off, worsening the employment prospects for the 3 million workers who have been unemployed for six months or longer and the over 2 million other "potential workers" who are not counted as unemployed. If the Fed raises rates too soon and too fast then it will make it harder for work hours to increase for the 7.1 million workers who are employed part-time but would rather be working full-time.
And such a course will slow progress on labor force participation and employment rates. The share of the population ages 25 to 54 — too old to be in school and too young to retire — participating in the workforce is down a whopping two percentage points since the Great Recession began, and the share of that same population with jobs has yet to recover half of its Great Recession losses. These indicators can and should improve. Raising interest rates will make that improvement more difficult.
These concerns betray the heart of the disagreement between the two camps of economists and policymakers: How much faith do you put in the unemployment rate as a measure of "labor market slack" — of the extent to which workers are being underutilized in the labor market? In my view, that the unemployment rate is falling faster than other indicators are improving suggests that the unemployment rate is no longer a "sufficient statistic" with which to gauge the health of the labor market. The labor market is not as healthy and normal as the unemployment rate suggests.
And then there's the balance of risks. Let's say I'm wrong about the unemployment rate but the Fed doesn't increase rates faster and swifter. In this case, we'll have some inflation. On the other hand, say that I'm right about the unemployment rate but the Fed tightens too quickly and too rapidly. In that case, a too-cool economy cools off even more, and millions of workers and potential workers who have been suffering for years have to wait even longer to return to full employment. And some surely won't ever return.
A little inflation above the Fed's preferred rate isn't the end of the world — it's a manageable problem, and may even be desirable. Letting millions of workers sit on the sidelines of the labor market is a bigger problem.
The fundamental logic of monetary policy is the same as it's been for years now: Prices aren't rising as rapidly as the Fed would like them to, and the labor market isn't using workers to their fullest extent. The Fed is still missing on both sides of its "dual mandate."
Prudence thus dictates a patient return to normal monetary policy. And the unemployment rate falling below 6 percent shouldn't fundamentally change anything.