June 08, 2015
Dean Baker
The Hankyoreh, June 8, 2015
View article at original source.
Most analysts are convinced the Federal Reserve Board will begin raising interest rates at some point in 2015. The weak data for the first quarter, which now shows the economy shrinking in the quarter, likely pushed back the date of the first increase towards the end of the year, but few doubt that a rate hike will come soon. This should be cause for serious concern.
The reason the Fed would raise interest rates is to slow the economy and reduce the pace of job creation. The argument is that the labor market is approaching full employment and if the economy were to continue to create jobs at a rapid pace, the excessive tightness of the labor market would lead to spiraling inflation. This view needs to be challenged.
The basis for the full employment view is that the unemployment rate has fallen sharply in the last two years, dropping from 7.6 percent in April of 2013 to 5.4 percent in April of 2015. With most economists putting the full employment level of unemployment in the range of 5.0–5.4 percent, it would appear that we are close to full employment, if not already there.
But on closer examination, it is not clear that the 2.2 percentage point drop in the unemployment rate means very much. The decline in the unemployment rate over this period was largely the result of people dropping out of the labor market. The percentage of the population that is in the labor force declined by 0.6 percentage points over the last two years, the equivalent of 1.5 million people leaving the labor market, meaning that they are neither working nor looking for work and therefore counted as unemployed. This is the opposite of the pattern we usually see, where the labor force participation rises when the unemployment rate falls.
The share of the population that has jobs is still down by four full percentage points from its pre-recession level. The fall-off would more than five percentage points if we compared the employment rate to the peak of the prior business cycle in 2000.
Many have argued the decline in employment rates is due to the aging of the population, with a larger share of the country now in their retirement years, but the story is little different if we focus on just prime age workers, people between the ages of 25-54. The employment rate for this group is down by three percentage points from its pre-recession level and more than four percentage points when compared with 2000.
It is hard to envision any good story as to why to so many people in their prime working years, both men and women (the decline is comparable for both sexes), would have decided that they don’t feel like working. Furthermore, other measures of a slack labor market, most notably involuntary part-time employment, remain well above pre-recession levels. This should raise further questions about claims that we are near full employment.
This is not just an academic exercise. If the Fed raises interest rate to prevent the unemployment rate from falling at a point where the economy is still well below full employment, then it will needlessly be keeping millions of people out of work. Disproportionately, the people who will be denied employment are minorities and the less-educated. As a rule of thumb, the unemployment rate for African Americans is twice the unemployment rate for whites. The unemployment rate for African American teens is six times the white unemployment rate. These are the populations that will be hardest hit by the Fed’s decision to raise interest rates earlier and faster than necessary.
It is also important to recognize that the tightness of the labor market affects the ability of tens of millions of workers to get pay increases. The only time in the last four decades when most workers were able to share in the gains of economic growth was in the late 1990s, when the unemployment rate fell sharply, eventually bottoming out at just 3.8 percent in 2000. If we were to again see similarly tight labor markets most workers would likely see wage gains, but if the Fed prevents the labor market from tightening, the gains from growth will continue to go to those at the top.
It is difficult to see a good argument for the Fed to rush to raise interest rates. The pattern of inflation has been studied intensively by economists for many decades. No models show it surging upward in response to a labor market that is slightly tighter than is consistent with a stable inflation rate. If the Fed mistakenly allowed the unemployment rate to fall 0.5 percentage points below the level consistent with stable inflation, it would only result in a very modest increase in the inflation rate – on the order of 0.1–0.2 percentage points after a full year.
This risk seems a very small price to pay for allowing millions of workers to get jobs and for tens of millions to get pay raises. The other point that should be made much more frequently is that economists really don’t know how low the unemployment rate can go without triggering inflation. In the 1990s, virtually the entire profession agreed that 6.0 percent unemployment, or something close to it, was the lowest the unemployment rate could go without triggering inflation.
The profession was badly mistaken in this view, as then Fed Chair Alan Greenspan demonstrated by letting the unemployment rate fall to 3.8 percent, without triggering an inflationary spiral. There is no reason to believe that economists have any better understanding of the economy today than they did two decades ago. That should argue strongly against Fed rate hikes that will keep millions out of work and tens of millions from getting pay increases. That’s a huge price to pay based on a theory of the economy that could be wrong.
