Replacing the Unemployment Rate

The unemployment (UE) rate, which is a measure of the prevalence of unemployment as a percentage, is one half of the Federal Reserve’s dual mandate (the other half is inflation). Since the 2008-2009 financial crisis, the UE rate has been on the forefront of both financial and mainstream news. According to the Wall Street Journal, “[The UE rate] was used to justify the nearly $800 billion stimulus bill in 2009”. In addition, the stubbornly high UE rate was also used to defend the numerous rounds of quantitative easing. Thus, the UE rate is a key factor in decisions about fiscal policy as well as monetary policy.

In January, the unemployment rate fell to 6.6%. This is a significant improvement from its peak of 10% in late 2009. The downward trend in the unemployment rate has been cited as an indication of a strengthening economy, but there are reasons to believe it might not tell the entire story. According to the Wall Street Journal,

The unemployment rate is falling so quickly in part because of many people dropping out of the labor force. The portion of Americans who are working or looking for work has been on a downward trajectory for many years, a process that gained momentum during the recession and which puts downward pressure on ratios of both employment and unemployment”.

Who are those dropping out of the labor force? On the one hand, some are part of the aging population. On the other hand, some are discouraged workers. As the economy returns to full speed, discouraged workers will hopefully be able to find jobs and return to the labor force (while those as part of the aging population will not return to the labor force). Although the economy is returning to full employment, the level of full employment will likely be lower.

For these reasons, I have started to lose faith in the UE rate as an effective economic indicator. According to the Wall Street Journal, “The unemployment rate, in short, is one of the most consequential numbers shaping our body politic. Unfortunately, it is the most misleading”. Not only does it misrepresent the health of the labor force, but it is also put on a pedestal and given outsized importance over other statistics. For example, the UE rate declined in both the January and December employment reports despite the number of jobs added falling significantly short of projections. I think the fact that the Fed is mandated to make decisions based on the UE rate is becoming a more obvious problem. As a result, I think the Fed should consider replacing the UE rate with another benchmark that better indicates when it needs to change monetary policy.

I am not alone in this belief. At the recent FOMC meeting, Fed officials explained they will not immediately change the course of monetary policy when the UE rate falls below the 6.5% threshold. The inappropriateness of the UE threshold is because it is a function of the labor-force participation rate, which means the UE rate can become distorted by events such as the expiration of unemployment benefits. An effective replacement might be a nominal GDP target, which represents real growth and real inflation. If the Fed can successfully target and achieve 4-5% nominal growth, then we would almost be back to our growth rate before the 2008-2009 financial crisis.