The Ben Bernanke Premature Taper Blues

In his news conference following the Fed's meeting last week, Chairman Ben Bernanke announced plans to end quantitative easing as soon as the unemployment rate falls below 7.0 percent. He also said that he now views full employment as being in the range of 5.5-6.0 percent. Both positions could be very bad news for the country's workers.

The first view means that just a small decline in the unemployment rate from the economy's current 7.6 percent will be sufficient to get the Fed to pull back its support. This is troubling because the economy will likely still have a long way to go to make up the jobs lost since the beginning of the downturn.

There has been substantial improvement in the unemployment rate since it peaked at 10.0 percent in the fall of 2009. However the story is quite different if we turn to the employment-to-population ratio (EPOP), the percentage of people who have jobs. This fell from 63.0 in 2007 to a low of 58.2 percent reached briefly in 2010 and again in 2011. We have made little progress in getting back to the pre-recession EPOP, with the EPOP standing at just 58.6 percent in May, almost 4.5 percentage points below its pre-recession level.

This drop corresponds to more than 9 million fewer people being without jobs. Some of the decline can be explained by the ageing of the baby boom cohorts increasing the number of retirees, but the vast majority of the drop in the EPOP is attributable to fewer prime age workers holding jobs. This suggests a large amount of labor market slack that should be confronted by a sustained response from the Fed.

Ironically Bernanke made this exact point about declining EPOPs back in January 2004 when he was justifying the Fed's decision to keep the federal funds rate at what was then considered an extraordinarily low 1.0 percent. Bernanke noted that the unemployment rate at the time was not terribly high, but pointed to a sharp decline in the EPOP from the pre-recession level. Since it was implausible that so many people had suddenly lost the desire or ability to work, Bernanke argued that the falling EPOP was strong evidence of continuing slack in the labor market.

Apparently Bernanke views the recent fall in the EPOP differently than the drop following the last recession. It is not clear how much impact the Fed's decision to cut back its quantitative easing (QE) will have on the economy (the market's fear of this cutback has already led to a jump in interest rates), but the economy is likely to need all the help it can get for the immediate future, and ending QE clearly goes in the wrong direction.

It is also not clear what Bernanke could possibly fear on the other side. The rate of inflation appears to be falling from already low levels. What could Bernanke fear from leaving QE in place for another year or two? Besides, a modest rise in the inflation rate would help to lower real interest rates and help homeowners rebuild equity.

If the ending of QE is bad news for the short-term, setting a target unemployment rate in the 5.5-6.0 percent range is terrible news for the longer term. The Fed may not always be able to boost the economy as much as it would like, but there is little doubt that it can slow growth and job creation by raising interest rates. If the Fed believes the unemployment rate cannot safely fall below a 5.5-6.0 percent range without generating inflation then it can ensure that unemployment will never fall enough to test this hypothesis.

This brings us to the one great success of the Greenspan years as Fed chairman. In the early and mid-1990s there was near unanimity in the mainstream of the economics profession that the unemployment rate could not fall much below 6.0 percent without triggering a dangerous acceleration in the inflation rate. This was the reason that Alan Greenspan raised the federal funds rate from 3.0 percent in February of 1994 to 6.0 percent the following year. He wanted to slow the economy and keep it from generating enough jobs to lower the unemployment rate further.

The interest rate hikes accomplished this goal. However in the summer of 1995, with the unemployment rate at 5.7 percent, the bottom edge of the economics profession's safe zone, Greenspan decided to lower interest rates to boost growth. In doing so he had to fight with other members of the Fed's board of governors, including two more liberal Clinton appointees.

Greenspan turned out to be right. Later in the decade the unemployment rate fell below 5.0 percent and eventually settled down at 4.0 percent as a year-round average in 2000. This meant millions more people were working. The low unemployment rate also tightened up labor markets to the point that even workers at the bottom were able to see wage gains and share in the benefits of economic growth.

However, we never would have seen this experiment with low unemployment except for the fluke that Alan Greenspan was not a mainstream economist. He did not accept the 6.0 percent floor on unemployment. The result was a late 1990's boom in which most of the country could share in the benefits.

If Ben Bernanke reinstates a floor on the unemployment rate in 5.5-6.0 percent rate then we may be stuck with it for a long time. It is not likely that we will see brave Fed governors prepared to challenge this target. That could mean millions of workers will be needlessly denied jobs. It also means that large segments of the labor force will lack the bargaining power needed to share in the economy's growth. That is indeed a gloomy picture for the future.