The Federal Reserve Needs to be Patient

The Federal Reserve has adapted a new stance on monetary policy: patience. With the federal funds rate at the zero lower bound since 2006, the Fed’s policy-setting committee, the FOMC, has delicately approached the idea of beginning to raise rates. Beginning in 2012, the Fed assured the markets that there would be a considerable time period of highly accommodative monetary policy to bolster the economy’s progression to the Fed’s dual mandate of maximum employment and stable prices.

During the last two FOMC meetings, the committee decided to exclude the language of “considerable time” from the statement and adopted a new vow to remain “patient in beginning to normalize the stance of monetary policy.” The statement assessed that labor market conditions were improving and that labor market slack, or underutilization, has continued to diminish. Following robust job gains at the end of 2014 and a significant drop in the headline unemployment rate, which is now down to 5.6 percent, a quick glance at the labor market looks more reassuring than reality.

There are still 6.8 million workers who are employed part time for economic reasons, 2.3 million workers who were marginally attached to the labor force, and 740,000 workers who were discouraged from looking for work since they did not believe there would be any employment opportunities. Over the past twelve months, there has been little change in underemployment. The U-6 alternative measure of broad labor market underutilization, which is at 11.2 percent, has remained twice the size of the headline U-3 unemployment rate. This is drastically above pre-recession norms, when there was a 3 percentage point differential in the rates compared to the 5.6 percentage point difference today.

In the past 35 years, the unemployment rate has generally been considered a good measure of labor market health (Barnes et al. 2007). However, the recent improvements in the headline (U-3) unemployment rate have overstated the health of the entire labor market. The FOMC learned this first hand. In 2012, the committee decided to target a 6-1/2 percent unemployment threshold to assure the market that rate rises would be delayed. Even with an unemployment rate nearing 5-1/2 percent, the FOMC has been forced to backtrack and recognize that this threshold was shortsighted. At the 2014 annual Jackson Hole conference, Janet Yellen claimed that the “decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions.”

In order to assess the amount of residual labor market slack, I created an aggregate distance function summing eight different labor market indicators from the distance of their pre-recession norms. Over the past year, Chair Yellen has mentioned that a variety of labor market indicators are on her “labor market dashboard.” Using speeches over the past year, I gathered eight different labor market indicators that Chair Yellen has highlighted when talking about labor market health. This includes: total unemployment, total underemployment (U-6), the labor force participation rate, percent of unemployed who have been out of work for over 27 weeks, employment-population ratio, hires rate, quits rate, and the job openings rate. For each indicator, I examined the pre-recession average (2005 – 2007), and then found the indicator’s proportional magnitude distance from current levels.

graph 3


As demonstrated by the indicator, there is still significant labor market slack, even though it is diminishing.  The indicator has no form of weighting between the components, and assumes no structural changes in the labor market when using the 2005 – 2007 pre-recession. However, it is interesting to determine the relationship between labor market underutilization and wage growth.  By plotting this labor market indicator against total private average hourly earnings growth, I drew a line of best-fit wage curve through the relationship of wage growth and labor market slack.