There has been intense speculation over the last several weeks that the Fed would change its guidance on the unemployment rate threshold from 6.5% to 5.5%. This is the unemployment level at which the Fed would consider starting to raise interest rates.
The rumor was fueled by a research paper written by William English, who heads up the Fed’s monetary affairs division. In the paper, released in early November, English argued that the threshold would be more effective if it were dropped as low as 5.5%, echoing earlier discussions by Fed officials. The goal of this would have been to convince investors that interest rates would remain low – less than 1% is average interest rate on a CD right now – even as the economy picks up steam and the Fed starts to wrap up its quantitative easing efforts.
The rationale for dropping the threshold was that while the unemployment rate in the US has continued to drop, the reality is that many potential workers have left the market, discouraged by poor job prospects. According to the argument, readjusting the threshold would merely reflect the reality of this situation – that real unemployment in the US is significantly higher than the official figures. Viewed through this lens, dropping the threshold merely brought it into line with the reality of the situation – and did not signal additional economic stimulus.
However, a speech by the Fed chairman, Ben Bernanke, seems to have put this notion to bed. In the speech, given on November 20th, he made it clear that the Fed was hesitant to drop the threshold, stating that “after the unemployment threshold is crossed, many other indicators become relevant to a comprehensive judgment of the health of the labor market, including such measures as payroll employment, labor force participation, and the rates of hiring and separation. In particular, even after unemployment drops below 6.5 %, and so long as inflation remains well behaved, the Committee can be patient in seeking assurance that the labor market is sufficiently strong before considering any increase in its target for the Federal funds rate.”
Part of the reason for this is that such a move could undermine the Fed’s credibility, and specifically that of the threshold. This would cause investors to start to doubt the Fed’s guidance in general – since malleable guidance indicates a lack of clear understanding and direction. This was a view put forward by the Federal Reserve Bank of St. Louis President James Bullard on the same day that Bernanke made his speech. In fact, Bullard argued that rather than focusing on this, effort should be directed to starting to raise inflation – with the central bank’s inflation measure currently below 1%, deflation is a significant risk. Again echoing Bernanke’s view, Bullard favored additional guidance that low inflation would lower the likelihood of economic stimulus being reduced, rather than changing the existing unemployment threshold guidance. This would have the effect of continuing to create positive sentiments among investors while maintaining the Fed’s credibility.