Employment Is Down: Can the Fed Do Anything?

Editors' pick: Originally published June 8.

May's job numbers were borderline disastrous.

In its monthly numbers released last week the Bureau of Labor Statistics reported a set of grim data. Job creation was less than a quarter of what analysts predicted, a meager 38,000 positions out of an anticipated 160,000. The unemployment rate ostensibly fell by 0.3 points, but the labor force participation rate plummeted to its lowest point in over a year. The adjusted unemployment rate (which accounts for labor force participation) held at 9.7%.

Making matters worse, the BLS also adjusted its numbers for the previous two months, revising their estimates for job creation in April and March downward. All in all, it paints a disturbing picture for the economy (one that has Democrats gripping their seats heading into an election).

All eyes are now on the Federal Reserve to see how it will respond.

The standard model in response to weak employment is for the Federal Reserve to lower short term interest rates. As explained by L. Josh Bivens with the Economic Policy Institute, this increases economic activity across the marketplace as both consumers and businesses get easier access to long-term loans for homes, cars and equipment.

"The Fed tries to boost aggregate demand with lower interest rates, and the resulting increase in the pace of economic growth puts downward pressure on unemployment," he said. "Basically, businesses see higher demand for the goods and services they provide, so they are forced to add workers to meet this higher demand and this reduces unemployment."

There are two problems, however.

Thanks to years of low interest rates when the Fed meets later this month, it won't have much room to move. After a minor hike in December, the short term interest rate sits at 0.25%, a number small enough that investors such as Kate Warne with Edward Jones argue that cutting it would make relatively little difference to the jobs market.

Also troubling to some, but not all, observers is inflation. After years of near-zero inflation it has finally begun creeping up, reaching 1.1% in April. While this is still below the Federal Reserve's target 2% rate, critics of continued low interest rates argue that it is the trend lines which matter.

Warne is one of those concerned.

Arguing that the rising inflation isn't necessarily worrisome yet, Warne said that it still signals the beginning of the end to the need for extraordinary policies.

Moreover, investors need to be concerned with unintended side effects.

"I think there are arguments to be made that keeping rates at zero, if they haven't yet encouraged borrowing that shouldn't occur, they'll do so," she said. "We know that, historically, keeping rates too low for too long has resulted in financial excesses. I don't think we're seeing that yet, but I don't think it makes sense that we continue a zero rate policy in an environment where the rates shouldn't be zero."

Where money is cheaper than it needs to be, Warne said, credit bubbles can form. There's no reason to think that this exists just yet, but it could be on the horizon is the Federal Reserve artificially holds down rates for too long.

Not everyone believes that inflation or credit bubbles are an imminent concern. As Jesse Rothstein, Director of the Institute for Research on Labor and Unemployment with Berkeley, argued, the dispositive question is whether inflation has become troubling rate yet.

"Raising rates now is cutting off the recovery before it gets going," he said. "Inflation is trending towards where we want it to be. If the target is 2%, we're still below it. So it seems unreasonable to me that any approach towards the target is a sign that we're getting too high. That will guarantee that you never reach the target."

"It's not clear why you want to raise rates," Rothstein added, "which would raise unemployment and keep inflation down when there's no evidence that you need to keep inflation down."

However, this is precisely what the Federal Reserve has signaled its intention to do.

In the months leading up to May's job report, the Fed has consistently telegraphed plans for another rate hike at its June meeting. This has frustrated analysts like Rothstein, who believe that it is over-responding to inflationary pressures not yet manifest in the market, while easing the concerns of those who believe that the Fed needs to respond to the direction that inflation is headed.

Most observers agree that May's job report has largely eliminated the possibility of a rate hike this month, with the Federal Reserve unlikely to restrain new hiring.

Inflation aside, keeping rates low could also have the benefit of slowing down a strong dollar.

"One of the major problems with Janet Yellen beating the drums of raising rates all last year was it drove the dollar weighted trade index up," said Brett Ewing, chief market strategist for the financial services firm First Franklin. "It created all that volatility, and currencies around the world dropped dramatically against the dollar."

By restricting the money supply a change in interest rates can influence the value of the dollar, reducing available cash in circulation relative to other currencies. The resulting strength, however, can hurt American exports and the industries which depend on them, which by some estimates accounts for roughly 18% of the economy.

Specifically, Ewing argued, the dollar has gained strength too quickly. Companies need time to adjust to increasingly expensive exports, but America raised its interest rates and signaled more to come while many countries in Europe and the rest of the world were busy slashing theirs.

"We're the cleanest dirty shirt in the laundry basket," Ewing said. "You can have a rising dollar and everything can work great. It's when it goes up so fast in such a short amount of time that no one can adjust."

What's more, after months of signaling to the market that it was preparing to raise interest rates, a sudden reversal could be potentially destabilizing.

As Ewing pointed out, the Fed has been "guiding the market" toward a rate hike in June. With investors prepared for that, an about-face in policy could create real problems for some.

As a result of these conflicting forces most analysts think that that the Federal Reserve's response will be simple: nothing.

"My guess is that they will not do a lot in the next meeting" Rothstein said, "They will continue to talk about how they foresee tightening later, but they're not quite there yet."

May's job numbers represent just one month, as Yellen argued in a recent speech. While the BLS statistics do look bad, they also don't necessarily mark the beginning of a trend. Indeed, Biven believes that outside influences such as the strike at Verizon could have drained as many as 35,000 jobs in lost economic activity.

Without a clear way of knowing whether May was a blip or the beginning of a trend it's likely too early for the Board to take decisive action. Although the Board has been poised to raise rates, and may do so later this year, a hike after such poor numbers could potentially throw cold water on hiring at a bad time.

Continued low interest rates, on the other hand, will probably have relatively little impact other than ongoing stimulus to a certain degree. Rates have been zero, or close to, for years. They will continue to encourage some hiring, but the job market would be more likely to respond to a hike in interest rates than continuing to keep them low.

All in all, the takeaway from May is probably simple:

"We all know economic data tend to be bumpy from month to month and tend to be revised," Warne said. "I don't think it changes their view overall very much."

"We think a June hike is off the table," agreed Ewing, "and I don't think you'll see one in July."

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