Keep Rates Low until the Hidden Jobless Return to Work

Op-ed in the Financial Times

August 19, 2014

This year's annual conference of central bankers in Jackson Hole is focused on the right question: how to determine the extent of labor market slack in the United States and other advanced economies. This is the most pressing issue for Janet Yellen, Federal Reserve chairwoman, and her colleagues, given the limits of what monetary policy can do about structural unemployment.

There has been a legitimate debate over what lies behind the low US labor force participation rate, which measures the proportion of adults who are either working or looking for work. Some blame demographics, with two large cohorts (aging baby boomers and women of child-bearing age) both disproportionately likely to leave the workforce. Eight years ago, a group of Federal Reserve staff predicted in an academic paper that labor force participation would fall to about 63 percent this year for precisely this reason. That turned out to be eerily close to reality, suggesting the United States may be at full employment. If so, there is nothing the Fed can do to improve matters; it would cause inflation if it tried.

The conclusion that ought to emerge from Jackson Hole [is that] [t]he Fed should hold off raising rates for the sake of fuller employment.

Others take a different view, arguing that wages are being held down in areas of the country where statisticians count more people as unemployed or no longer looking for work. This pattern is confirmed by analysis of employment and wage data for different localities and states. The implication is clear: Some portion of those who are seen in official statistics as having left the workforce are nonetheless viewed by employers as prospective hires, weakening the position of workers in wage talks.

This statistically significant pattern offers a better picture of actual hiring decisions than national demographic data. It takes account of local conditions that might obscure the true picture. And it explains why wages have not been rising nationally, as one would expect if the United States were approaching full employment.

Still, any decision by the Federal Open Market Committee to hold off raising interest rates will not be made on data alone. At least two other judgments are involved.

The first concerns the relative costs of erring in one direction or another, given the unavoidable uncertainty. For most of the past three decades central bankers have assumed that allowing inflation to overshoot would lead to explosive upward spirals in prices. By contrast, overshooting on unemployment was assumed to have little lasting effect. The risks were seen as asymmetric. No chances were to be taken with inflation for the sake of employment.

It has become clear, however, that those assumptions should be reversed under conditions of persistent low inflation and slow growth. Even if it overshoots briefly, people are unlikely to expect high inflation to stick in the face of weak demand, particularly for labor; expectations are well-anchored. This was demonstrated by the experience in the United Kingdom in 2010–11, when the Bank of England's Monetary Policy Committee held its fire on interest rates as inflation briefly spiked due to short-term shocks, and inflation came back down nonetheless.

Meanwhile, there is growing evidence that long-term unemployment, or even underemployment, does lasting damage to the ability of younger people to find work that pays well throughout their working lives. Under current conditions it is labor slack that does lasting damage, whereas brief inflationary episodes will have only a transient impact.

The second issue is whether keeping interest rates low will do some other form of harm, which outweighs the potential benefits of large numbers of people returning to work. The most obvious concern, which has been mentioned by a number of former senior officials, is for financial stability. After the global financial crisis, no one can dispute that central banks have to take financial stability into account when making policy. But that does not mean that they must rush to raise interest rates.

Financial imbalances can be tackled directly using macroprudential tools, which work by constraining the amount of credit that banks are allowed to extend or that borrowers can access. These are being used in China, Singapore, the United Kingdom, and elsewhere. They have proved effective when applied aggressively. By contrast, increasing interest rates has little effect on asset price booms, despite repeated calls to use interest rates for financial rather than cyclical stabilization.

This is the conclusion that ought to emerge from Jackson Hole. The Fed should hold off raising rates for the sake of fuller employment.

There are clear indications that wage growth is being kept down by the overall state of the labor market, and raising rates would further depress demand. Allowing excess unemployment to persist is likely to do more lasting damage than allowing inflation to rise above the target—and any such overshoot will be temporary. Concerns about financial stability should be addressed directly, not through the blunt instruments of monetary policy.

As Fed chairman in the 1980s, Paul Volcker was right to resist calls to loosen monetary policy in the face of high unemployment, at a time when spiraling inflation would have done lasting damage. Now the risks are reversed, and the right course is to hold off rate rises to tackle persistent unemployment that threatens permanent harm. This, too, will attract criticism. But, like their predecessors, Ms. Yellen and the Federal Open Market Committee need to hang tough.