The Fed should get smart and stop ‘targeting’ unemployment

According to The Economist:

One key indicator to assess the health of this is America’s unemployment rate. But this may be less useful now than it once was. Although the number of jobless Americans has fallen, the share of the working-age population in the labour force has also dropped considerably, from 66% before the financial crisis to less than 63% now. Temporary factors have affected the statistics, but much of the change has been driven by structural factors, such as retirement of the baby-boomer generation and rising college enrollment. These developments may explain why, as the unemployment rate has fallen from 10% in 2009 to 5.4% today, the Fed’s target long-run unemployment rate has also declined, from 6% in 2013 to just 5.2% at present.

But what alternative indicators are there? Fed officials have drawn on a number of other economic indicators, such as labour-force participation rate or wage growth, to assess the level of remaining slack in the economy. Another approach is to estimate the number of Americans currently on the sidelines who could be coaxed into rejoining the labour market if conditions improve. Researchers at the Fed and the IMF have estimated that a stronger jobs market could boost the labour-force participation rate by as much as 0.75 of a percentage point, which is equivalent to about 1.9m workers. This would suggest that America’s true unemployment rate may be nearer 6.6% than the official figure of 5.4%.

Economists say that fixed-investment volumes may also be a better indicator. Back in 2011, John Taylor of Stanford University pointed out that since the early 1990s, unemployment rates have been lower in America during periods of high investment spending. For each percentage point increase in the investment share of GDP, unemployment falls by between 0.5 to 1.5 percentage points. But in recent months, the relationship between the two has weakened. Today, fixed-investment levels would predict an unemployment rate of roughly 6.5%, much more than the official 5.4% figure. There could be as many as 2m “missing” unemployed Americans excluded from the data the Fed uses to set interest rates. When the economy is so fragile, that’s not good news.

The alternative indicators arrive at almost exactly the same ‘true’ unemployment rate, which is quite a bit higher than the official figure. However, given it is itching to raise rates, the Fed is sticking to its guns. Unless, once again, they will feel compelled by reality to reduce the target!

Why is there a correlation between the share of private investment and the unemployment rate?  There’s no coincidence here, it’s just that both magnitudes react to economic prospects. The “fallen chalice” chart below depicts this correlation. It also tells us that during the recovery(!) phase of the past five years, unemployment has reacted quite a bit more strongly, indicating something could be “fishy” in its measurement.