Fed too familiar with lost labor seeking new message for policy

Staff Writer
Columbus CEO

(c) 2013, Bloomberg News.

It's becoming increasingly clear why Federal Reserve Chairman Ben Bernanke should have avoided linking the central bank's policy decisions to specific unemployment rates.

Bernanke said in June he expected the Fed would complete its bond buying when the jobless level was around 7 percent, and policy makers have pledged since December they won't consider raising interest rates as long as it exceeds 6.5 percent. With a decline in August to 7.3 percent for the wrong reason — Americans giving up on finding work — Fed officials are being forced to shift their guideposts.

The flawed measure has contributed to the market's confusion over the direction of monetary policy, and Fed officials now are struggling with how to minimize it as a policy benchmark without damaging their credibility, according to Ethan Harris, co-head of global economics research at Bank of America Corp. in New York. The Federal Open Market Committee's Sept. 18 decision not to taper its $85 billion in monthly bond buying surprised investors across the globe.

"Picking the unemployment rate as the key growth-side indicator was a huge mistake for the Fed," said Harris, one of the few economists to correctly predict the Fed wouldn't taper in September. "It was supposed to be a marker that the average Joe could look at and say, 'Ah! OK, now we've hit a broad-based recovery.' Now, they've almost immediately abandoned it."

The day of the decision, Bernanke downplayed the 7 percent threshold he gave in June for the end of the central bank's quantitative easing, saying unemployment "is not necessarily a great measure" of the job market. He also suggested the 6.5 percent level for interest-rate increases may be too high.

"The committee would also take into account additional measures of labor-market conditions," Bernanke said Sept. 18. "Thus, the first increases in short-term rates might not occur until the unemployment rate is considerably below 6.5 percent."

The directives have misled investors and contributed to volatility in the markets, according to Bret Barker, a managing director in U.S. fixed income at Los Angeles-based TCW Group Inc., which manages more than $128 billion. He said the shrinking labor force was "always the problem" with measuring unemployment, yet the Fed went ahead anyway and tied its policies to the gauge.

"How credible is your forward guidance if you're telling us to watch these numbers and then at the press conference you're telling us to discount them?" Barker said. "The message of the Fed has been kind of muddled from the get-go since May, and I don't think the meeting last week helped clear that up at all."

Bernanke's remarks earlier this year about the prospects for Fed tapering sent yields on the benchmark 10-year Treasury note as high as 2.99 percent on Sept. 5 from 1.93 percent on May 21, the day before he first outlined a possible timetable for a reduction in the asset purchases. Ten-year yields have fallen since then to 2.62 percent at 5 p.m. on Sept. 27 in New York after the Fed decided against paring its stimulus, Bloomberg Bond Trader prices show.

As central bankers try to reset policy expectations, they're playing down the importance of the unemployment figures. Federal Reserve Bank of New York President William C. Dudley said Sept. 23 that the decline in joblessness "overstates the degree of improvement." Other measures, such as hiring and job openings point to "much more modest" progress, he said in a speech in New York.

Unemployment fell to 7.3 percent in August from 7.4 percent in July and 7.6 percent in June as workers left the labor force and payrolls in the U.S. climbed less than forecast. The share of working-age people in the labor force declined to 63.2 percent, the lowest participation rate since 1978, from 63.4 percent in July.

The Labor Department will release September data on Friday, Oct. 4. Joblessness will stay at 7.3 percent, according to economists in a Bloomberg survey, and employers will add 180,000 people to their payrolls, up from August's 169,000.

The Fed may wait "a long time" to raise its target for the federal funds rate after breaching the 6.5 percent threshold, Dudley said. Central bankers have kept the benchmark near zero since December 2008.

Bond traders have pushed back their expectations for an increase in short-term rates since the FOMC's September meeting. Federal funds futures contracts traded at CME Group Inc. gave a 29.6 percent probability as of Sept. 27 that the Fed will lift its benchmark by at least a quarter-percentage point at its December 2014 policy meeting, down from 45.6 percent odds on Sept. 17.

Bernanke's introduction of the unemployment threshold in the December FOMC statement is one of his latest transparency initiatives and followed the Fed's adoption of a 2 percent inflation target in January 2012. The Fed has a dual mandate of pursuing full employment and price stability.

The 59-year-old Fed chief, whose term expires Jan. 31, has run the most open central bank in its 100-year history, introducing regular press conferences and revealing officials' interest-rate forecasts as part of his efforts to increase the public's understanding of policy.

The jobless threshold is "part of their transparency policy, where you pick objectives that are supposed to be simple and clear to the public," said Bank of America's Harris. "Everyone knows what the unemployment rate is, and no one knows what gross domestic product is, so they picked the simplest summary" indicator of the economy.

The effort at clarity has backfired as the measure has failed to accurately represent labor-market conditions, according to John Silvia, chief economist at Wells Fargo Securities LLC in Charlotte, North Carolina.

"The Fed has tried to be very helpful and everything, but sometimes you can be way too specific and transparent," Silvia said. "You're telling me your guidepost is this very precise number which is not very precise? I'm not surprised the Fed is backing away from what I think was a bad decision."

The botched communications may damage confidence in the Fed's forward guidance, according to Silvia.

"Of course it has consequences for credibility because you're too darn specific," Silvia said. "If you say 'We're going to win the Super Bowl by 20 points' and you win by 15, everybody is disappointed."

St. Louis Fed President James Bullard has "argued against" using joblessness as a peg for the end of the central bank's third round of asset purchases, he said in a Sept. 20 interview at Bloomberg's headquarters in New York.

"The hazards of doing this have been illustrated with the most recent unemployment report, where unemployment went down, but only because labor-force participation went down," Bullard said. "I just don't think it's credible."

The FOMC also may want to adjust its guidance on borrowing- cost increases, said Bullard, who votes on policy this year. A "more likely" scenario than lowering the 6.5 percent jobless threshold is introducing an inflation floor, saying the Fed wouldn't raise rates "if inflation is below 1.5 percent."

The central bank's preferred inflation gauge — the personal-consumption-expenditures price index — rose 1.2 percent in August from a year earlier.

Not all central-bank officials are trying to walk back the link between policy and the unemployment rate. Fed Governor Jeremy Stein, who has backed record stimulus, said Sept. 26 the central bank should tie the winding down of its bond buying more closely to economic data like joblessness.

"My personal preference would be to make future step-downs a completely deterministic function of a labor-market indicator such as the unemployment rate or cumulative payroll growth over some period," Stein said in a speech in Frankfurt, Germany. "For example, one could cut monthly purchases by a set amount for each further 10-basis-point decline in the unemployment rate." Ten basis points equal 0.1 percentage point.

Shifting the unemployment marker would be problematic, according to Bullard.

"The threshold would start to lose meaning, because it would show that the committee was willing to move the threshold around," Bullard said. "And I think markets would rightly start to worry that the thresholds are just being moved around for convenience and they can easily be moved up again or ignored."

Bank of America's Harris agreed it's a bad idea for the Fed to monkey with the unemployment threshold, even though it's now "irrelevant."

"You don't want to micromanage it and call lots of attention to it," said Harris, a former New York Fed researcher and author of "Ben Bernanke's Fed: The Federal Reserve After Greenspan." "You use every opportunity you can to say how soft of a target it is."