Apr 01, 2015

Full Employment: Jobs vs. Inflation

Over the past few weeks, there has been much discussion among economists, analysts, and labor experts if the U.S. economy is on its way to full employment. But what exactly is full employment? Full employment does not mean that everyone has a job; rather it means that unemployment has fallen to the lowest possible level without provoking inflation. If unemployment falls too much, inflation will rise because employers are competing to hire workers and pushing wages up too quickly.

There is no magic number for what full employment is. According to many estimates, it’s a jobless rate of about 5 percent, not too much lower than the February rate of 5.5 percent. But this figure is not etched in stone, and there is a lot of debate about how much more unemployment can fall without causing inflation to rise. 

What is Inflation?

Inflation occurs when the prices of goods and services increase over time. Rather than an increase in the cost of one product or service, inflation is the general increase in the overall price level of goods and services in the economy. Changes in inflation are evaluated by monitoring several price indexes, which measure changes in the price of a group of goods and services. Inflation is measured as an annual percentage increase. As inflation rises, every dollar buys a smaller percentage of a good or service.

How Does Monetary Policy Influence Inflation and Jobs?

In the short run, monetary policy influences inflation and the economy-wide demand for goods and services. This in turn, impacts the demand for the employees who produce these goods and services, primarily through its influence on financial conditions facing households and firms. The Federal Reserve primarily influences financial conditions by adjusting the federal funds rate, which is the rate banks charge each other for short-term loans. These short-term interest rates influence borrowing costs for firms and households, and also influence long-term rates such as corporate bond rates and residential mortgage rates.

These changes in financial conditions affect economic activity. For example, when interest rates go down, it becomes cheaper to borrow, so households are more willing to buy goods and services and firms are better able to purchase items to expand business. Firms respond to increased business by hiring more workers and boosting production. As a result, household wealth increases, which prompts more spending. The linkage from monetary policy to production and employment does not appear immediately and is influenced by a range of factors.

Monetary policy influences inflation in that when interest rates are reduced, the stronger demand for goods and services tends to push wages and other costs higher, reflecting a greater demand for workers and materials that are needed for production.

Historically, the Fed raises rates as the economy strengthens in order to control growth and prevent inflation from going too high.

The Current Situation

Since recovery in the United States began in 2009, total employment rose from 138 million to 147 million by the end of 2014. Meanwhile, the number of unemployed people fell from 15 million to less than 9 million, and at the end of last year, job growth began to increase rapidly. Over the past 12 months, employers have consistently added more than 200,000 jobs every month. As the labor market tightens, the Federal Reserve is debating when to start raising interest rate. Since there is much confusion over how many people actually want to be employed, it’s difficult to determine how low unemployment can be while still keeping inflation at bay.

Staff at the Federal Reserve has been marking the natural rate of unemployment down since 2013 from 5.6 percent to 5 percent late last year. Research at several Fed banks puts the estimate as low as 4.7 percent, with reasons given such as structural downshift in growth, an aging workforce that is less likely to switch jobs, the sense that there are many people who want to rejoin the labor force, and the rise in the number of workers who choose to work part-time.

Further complicating the decision to raise the interest rate is the surging U.S. dollar, which is helping to keep inflation very low. A rate increase could send the dollar even higher.

Who is Really Unemployed?

The government counts unemployed people as those who do not have a job, have actively looked for a job in the previous four weeks, and are available for work. The Bureau of Labor Statistics reports that 2.3 million people were “marginally attached to the labor force” at the end of 2014, meaning they wanted a job and had looked for one in the previous 12 months, but not in the past 4 weeks. This included 740,000 discouraged workers who had stopped looking for a job. Additionally, at the end of 2014, 6.8 million of the economy’s 26.5 million part-time workers wanted a full-time job.

Labor Force Review

Labor Force Review

Source: BLS

Among the population who are marginally attached to the labor force, leading reasons for not looking for a job in the past 4 weeks include being discouraged over job prospects, family responsibilities, and more.

Reasons for Being Marginally Attached

Reasons for Being Marginally Attached

Source: BLS

The Federal Reserve’s Dilemma

Since 2008, the Federal Reserve has kept interest rates near zero. The Federal Reserve has a mandate to both maintain price stability (by keeping inflation at bay) and achieving full employment. Since inflation has consistently undershot the 2 percent target (the rate that the Federal Open Market Committee judged as the most consistent over the longer run), the argument for raising rates is that the country has reached full employment.

It is easy to sum up why this is a major area of concern for the economy by looking at both sides of the arguments to raise rates. Jim O’Sullivan of High Frequency Economics is concerned that by waiting to raise interest rates, it may still take many months for the interest rate policy to get back to normal, and then it will take another recession to bring inflation back in check. Meanwhile, Dean Baker of the Center for Economic and Policy Research argues that a rate hike any time this year will serve to stunt job growth. He argues that with inflation low in the U.S. and around the world, raising rates out of fear that inflation might rise is a bad policy when there are many Americans who are currently underpaid or underemployed. 

Since December 2014, the Fed has said it can be “patient” in beginning to raise the interest rate from its current record low of near zero. Many analysts believe that dropping the word “patient” from its statement will signal that the Federal Reserve is moving towards a rate increase, perhaps as soon as June 2015. During the latest Federal Open Market Committee Meeting in March 2015, economists and investors were waiting to see if the word “patient” would be removed from its policy statement. It turns out that the reference to being “patient” was dropped, signaling to some analysts that the Federal Reserve was opening doors to an interest rate increase at the end of the second quarter of 2015. The statement also indicated that the change in wording does not mean that the Federal Reserve has made a decision as to the timing on when there would be a rate hike. It further noted that rates will not increase until there is further improvement in the job market, and that it has confidence that inflation is moving closer to the 2 percent level.

“Just because we removed the word ‘patient’ from the statements doesn’t mean we’re going to be impatient.” ~Janet Yellen, Chair of Board of Governors of the Federal Reserve System

“I just don’t see any price or wage pressure out there. June is not off the table but it’s unlikely. September is the most likely time for the first rate hike. They might get one hike in this year, maybe two.” ~Craig Dismuke, Chief Economist at Vining Sparks