Timing the 6.5 Percent Unemployment Target

A paper by the Cleveland Federal Reserve Bank looks at why this recovery in the jobs market is so different than in past recoveries going all the way back to 1939 and, using three key economic factors, gives us a sense of when we might see the unemployment rate hit the Federal Reserve's magical 6.5 percent level.

Looking way, way back to 1946, the best six-month period of employment growth in the U.S. economy saw job gains of over 500,000 per month; when measured in terms of the size of today's labour market, that would be an increase of over 2,000,000 jobs per month!  As well, looking at the 75th percentile for growth in any sixth month period since then, monthly job gains of 450,000 are seen, a far cry from what we are seeing today.  Here is a graph showing the history of monthly job gains since 1980 showing just how unusual the current situation is:

Obviously, the labor market has changed a great deal, particularly over the past decade.  Three factors have impacted growth in America's labor force over the past five years:

1.) The level of economic growth.

2.) The labor force participation rate:  The authors suggest that the current labor force participation rate of 63.3 percent is very close to what the trend would suggest.  They project that labor force participation will continue to decline by about 0.33 percentage points per year as more baby boomers retire; this is different than most pervious recessions which showed a post-recessional bounce in the participation rate as more workers sought work.  Here is a graph showing the decline in the labor force participation rate:

3.) The level of dynamism or unemployment flow rates in the job market:   This factor is defined as the level of job finding and job separation.  The authors note that the flows of workers in and out of unemployment are low, reflecting a long-term decline in turnover.  Here is a graph showing the relatively low number of non-farm quits:

Here is a graph showing the relatively low number of non-farm separations:

Here is a graph showing the marked decline in the probability of finding a job compared to other post-recessional periods:

 These factors have worked together to keep America's workers from job-hopping.

Now, using a GDP growth rate of 3.1 percent (rather hefty considering recent numbers) derived from a typical cyclic response for this year, the authors suggest monthly employment gains of 149,000 will bring the unemployment rate down to 7 percent by the end of 2013 and that the unemployment rate will reach the Fed's magic number of 6.5 percent by the third quarter of 2014.  From there, the unemployment rate will continue to drop to the natural rate of unemployment which now stands at about 5.8 percent.  Once the unemployment rate is at 5.8 percent, it will only take employment gains of 46,000 per month to keep it there because of the declining labor force participation rate.

All that said, there are some flies in the ointment.

The Society of Professional Forecasters (SPF) projects that GDP growth will only be around 2.3 percent this year.  Using this lower and probably more realistic growth rate, unemployment drops to 7.3 percent by the end of 2013 and takes until the third quarter of 2015 to reach the magical 6.5 percent rate required by Mr. Bernanke et al as a signal to end current monetary policy.  Obviously, GDP growth rates play a very significant role in employment growth.

From the first graph in this posting, it's quite apparent that the monthly job gains seen since the end of the Great Recession are below normal and it is highly unlikely that the economy will return to the halcyon days of the 1980s when it was common to see average annual monthly job creation numbers in excess of 200,000 as shown on this graph:

With that in mind, the authors created an alternative scenario with employment growth of 106,000 jobs per month this year, increasing to 165,000 per month in 2014 and 224,000 per month in 2015 with a 2.3 percent growth in GDP and a bounce-back in the labor force participation rate.  This scenario also  sees the unemployment rate drop to 6.5 percent by the third quarter of 2014.    

If Mr. Bernanke sticks to his guns about ending his monetary experiment when the unemployment rate hits the arbitrarily chosen 6.5 percent target, it looks like the Federal Reserve could well own a great deal more of America's mortgage and federal government debt since it is unlikely that the target will be met until, at the very least, one year from now.  Key to the future drop in the unemployment rate is the growth rate of the economy; unfortunately, the growth rate looks far from robust compared to other recoveries, suggesting that the 6.5 percent target will be very difficult to meet any time soon.