For Janet Yellen and the Fed, falling unemployment hardly matters

At the start of 2015, it looked highly likely that the Federal Reserve would finally let interest rates rise during its June 2015 meeting. The job market had been on a tear, after all, and the expectations were that the rest of the economy would soon join it, with hiring pressures leading to higher wages, which would lead to more consumer spending and a boost in GDP.

That hasn't quite happened, and Federal Reserve Chair Janet Yellen said in a speech Friday afternoon that a rate hike can be expected later in 2015. “I think it will be appropriate at some point this year to take the initial step to raise the federal-funds rate target and begin the process of normalizing monetary policy,” Ms. Yellen said in remarks to the Greater Providence Chamber of Commerce in Providence, R.I.

“Even with the significant gains in the past couple of years, it is only now, six years after the recession ended, that the labor market is approaching full strength,” she continued . “I say ‘approaching’ because in my judgment we are not there yet.”

With just the unemployment rate to go on, such caution might be surprising.  People who study the labor market, especially during recovery periods, often reference something called “full employment.” Also called “natural unemployment,” it’s basically an acceptable percentage of joblessness, above zero, for an economy at full strength (In economists' minds, zero percent unemployment is not ideal because it could send price inflation skyrocketing). In a full-employment environment, the space between the number of people seeking jobs and the number of jobs available is tight.

In lean times, like a recession with high levels of joblessness, the natural unemployment rate can be a handy goalpost for a return to normal – "the economy will be fully recovered when we hit (x) percent unemployment,” we might hear. In addition to being something to look forward to, that little number can play a big part in influencing economic policy decisions, like ending the Fed's quantitative easing program and when to raise those pesky interest rates.

There’s just one problem: No one can agree on what the natural unemployment rate actually is. Historically, it’s been pegged at somewhere between 5 and 5.5 percent, which is still the number that many economists cite. In 2014, a report from the Congressional Budget Office said four percent – last achieved during the Clinton-era 90s – was a more realistic estimate. On Wednesday, during an remarks at an economic conference in Munich, Chicago Fed President Charles Evans said that the current 5.4 percent jobless rate was about “a half a percentage point” above what he would consider normal.

The “full employment” question has become even cloudier in recent months, because by many estimates, we should be nearing it. The economy has averaged about 230,000 monthly jobs added in 2014 and the first four months of 2015, and the unemployment rate has fallen about a percentage point each of the past four years. 

But although the headline number looks good, the rest of the employment picture gives plenty of cause for worry. Wages are depressed, and the labor force participation rate – the percentage of Americans working or actively looking for work – is at its lowest level in nearly four decades. Some of that is due to an exodus of retiring Baby Boomers, but participation rates among 18 to 24-year-olds are also falling. Since peaking in the late 1990s, the percentage of women in the workforce fell to a 27-year low in April.

In addition to factors like surging childcare costs (which are playing a part in women dropping out) and retirement, both workers and employers may have lingering caution about entering the workforce, says Diane Lim, an economist with the Committee for Economic Development, a moderate Washington think tank.

“We don’t know how many people are going to come back into the labor force,” she says. “It’s a huge problem that wages aren’t growing faster, because it suggests the demand for labor is not really strong. There’s enough uncertainty in the part of businesses that they [still] aren’t ready to get in like they were before the Great Recession.”

All of that makes it hard for the Fed to rely on jobs numbers at all in making its rate decision – and with the economy disappointing in other areas, it clouds the question of the timing of a hike even further. "The Fed is not just looking at that one number," Ms. Lim says. "We’ve never been [in an economy like this] before, so looking at past data [like 'full employment' rates during boom times] doesn't help us as much."