How Does the Fed Combat Unemployment?

In the wake of May's job numbers, much of the talk has surrounded what the Federal Reserve can do to respond to a dismal month for hiring. Although it has long signaled an intention to raise interest rates at its June meeting, the Fed is expected to abandon that plan in favor of continued stimulus.

It's worth addressing, at this point, how exactly the Federal Reserve influences employment, because its methods are a little arcane.

The government has two main mechanisms to combat unemployment: fiscal policy and monetary. Fiscal policy is pursued by changes to taxing and spending. An overheating economy can be cooled by raising taxes, taking spending power out of consumers' pockets and reducing upward pressure on prices.

Doing so is unpopular.

In a sluggish economy, the government can intervene as the so-called "spender of last resort," pumping in cash either by direct dispersals (such as unemployment insurance) or buying products and hiring workers (such as the stimulus act).

Increased gridlock in Congress has made fiscal policy increasingly difficult. Many right wing lawmakers view it as excessive spending, and exactly the kind of market intervention they oppose.

Which leaves monetary policy, effected by manipulating the cash supply. This is the primary role of the Fed and its dual mandate of encouraging full employment while combatting inflation. It has four key tools that it uses:

Interest Rates

Interest rates are the primary way that the Federal Reserve influences employment. In this context it refers to short term interest, which is paid for overnight deposits. This is as opposed to long term interest rates, such as those for a car loan, a mortgage or student debt.

It's the relationship between short and long term interest rates that influences employment, and one of the dirty little secrets of economics is that this connection is… tenuous.

"There's a somewhat mysterious avenue by which changing the short term rates changing the long term rates," said Jesse Rothstein, director of the Institute for Research on Labor and Employment at Berkeley University, "and the circumstances under which that's true are somewhat complicated."

Quantitative Easing

Many readers may have heard the term "extraordinary measures" used in reference to the Federal Reserve, and that generally is in reference to the bank's use of quantitative easing. It's another way of pushing down long term interest rates by purchasing large amounts of debt from financial institutions. This floods those banks with capital, and (ideally) encourages lending at cheaper rates thanks to the increased institutional cash flow.

This is an approach which the Federal Reserve employs when short-term interest rates are at or near zero, as they have been for the past several years.

"It's more of an extraordinary response to an extraordinary circumstance," said Kate Warne, an investment strategist with Edward Jones. "That doesn't mean, however, that once used they won't continue to use it, even though there was a fair amount of debate about whether it was effective."

Market Expectations

"The other big tool," Warne said, "is commentary."

The Federal Reserve is a vastly powerful institution, and its decision on interest rates affects employment, investments, inflation and even the strength of the U.S. dollar. As a result, setting expectations for what it will do in the months ahead can have a powerful impact on the markets. Investors and businesses who expect interest rates to go up, for example, may scramble to spend sooner rather than later, locking in known-spending before things get more expensive.

An announcement of rate cuts may have the opposite affect, while at the same time stimulating interest in a job market that may be about to get stronger.

The Fed's ability to set expectations is somewhat unpredictable, but it is an important asset nonetheless.

Inflation

Not all inflation is bad.

Although we describe the strength of the dollar in the value-based terms of "strong" and "weak," in fact inflation can have value. It's why the Federal Reserve actually targets 2%, rather than zero, as its ideal.

"The phrase that's sometimes used is it greases the wheels of the labor market," Rothstein said. "Sometimes it makes sense to lower somebody's real wage, because the nature of the market has changed and they are less productive, but in practice it's seen as almost impossible to cut somebody's wages while they're on the job."

Instead, he said, companies that need or want to save money on a worker can leave wages stagnant and allow fiscal erosion to take care of the rest.

It can also be valuable when it comes to long term loans.

"If everybody knows the inflation rate is going to be 2% every year, then we just build that into the mortgage contracts that we write," he said. "That's one reason why it's costly for the inflation rate to be lower than the target, because if people agreed to mortgages that [anticipated] 2% and the inflation turned out to be at 1.5% then basically borrowers are losing as a result of this. It's like the mortgage is getting bigger."

Data Driven Rates

The criticism of the Fed's process, however, is that it's an incredibly important series of decisions that happen in a black box. No one quite knows what will trigger the Fed to decide when rates should change aside from general, qualitative concerns.

As a result, some economists have begun to push for a more transparent approach.

"They should say that they're going to adopt a data-driven policy going forward," Rothstein said, "and that they won't raise until there's clear evidence that inflation is on a road to exceed 2% in the near future. And I think they could define exactly what would count. That would give a lot of clarity to the market."

Under this model the Fed would give, if not a commitment to specific triggers, at least certain conditions under which it will change interest rates.

"They could explicitly target a particular long-term rate," suggested L. Josh Bivens, an economist with the Economic Policy Institute. "Say, 'We want the 10-year Treasury rate to go to 1%. and we'll buy as many bonds as necessary to make that happen.' I think that would have measurable effects in boosting demand growth."

Employment

Economists liken the Fed's decisions to steering a tanker; it takes a long time to change course, but the effects can be enormous.

"They don't do anything that directly affects the result that they're supposed to achieve," said Warne. "It's always indirect. It's always through trying to select appropriate policy for the conditions they see in the economy, to essentially nudge things in the direction that would be better."

Reducing interest makes access to cash cheaper. As long-term rates get less expensive, it becomes easier for businesses and individuals to afford loans, creating demand for big-ticket items in both the consumer sector (such as homes, cars and appliances) and the corporate sector (such as expansion, office equipment and even staff). The availability of reduced interest also opens up opportunities to refinance at lower rates, which also creates additional spending power by freeing up capital.

This new spending allows businesses to grow with demand, giving them both the means and the motive to hire new employees. Ideally, this creates an expanded consumer base which continues the cycle of growth (creating the danger of inflation when consumer spending power begins to outgrow the availability of goods and services, causing the Federal Reserve to raise interest rates to slow the cycle down).

In other words, economic activity is a little bit like a bicycle. Once it gets started, it has a way of self-perpetuating, but occasionally needs an outside push when things get wobbly.

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