The Unemployment Rate is Just One Indicator

One criticism of the Fed’s recent communication strategy has been that it relied too heavily on the unemployment rate as an indicator of the health of the labor market and communicated that reliance to the market. As I wrote earlier, the unemployment rate is falling, but the economy is barely improving. In his June prepared statement, Fed Chairman Ben Bernanke said:

And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains

The Fed projections at the time expected the unemployment rate to be at 7.2-7.3% in the fourth quarter of this year. In August, the unemployment rate fell to 7.3%, well ahead of the Fed’s projections. Except this was not the result of above-average economic growth. On the contrary, financial markets tightened and the August jobs report was disappointing.  The drop in the unemployment rate was not representative of the overall economy.

Bernanke had hinted that the unemployment rate would be around 7% when asset purchases fully ended, but it had not even begun tapering yet. That was one major reason that so many journalists and investors expected the taper last week. Yet, this is once again not the Fed’s fault. The central bank could have done better in a number of areas. The long silence from the Fed governors provided little guidance for investors and Bernanke should have emphasized more that the Fed uses many different pieces of economic data to judge the labor market, not just the unemployment rate. But fundamentally, this was the market misreading the Fed.

Investors took one economic indicator and assumed the Fed would base its monetary policy on it. Worse, they knew that the drop in the unemployment rate was not the result of improving economic growth. It should have been common sense that the Fed would not that into account. But it wasn’t. There’s no doubt the Fed and Bernanke could have been more clear, like NY Fed president BIll Dudley was today and Bernanke was in his press conference last week. There, the chairman emphasized that the Fed looks at other economic indicators as well:

Last time, I gave a 7 percent as an indicative number to give you some sense of, you know, where that might be. But as my first answer suggested, the unemployment rate is not necessarily a great measure in all circumstances of the–of the state of the labor market overall. For example, just last month, the decline in unemployment rate came about more than entirely because declining participation, not because of increased jobs. So, what we will be looking at is the overall labor market situation, including the unemployment rate, but including other factors as well. But in particular, there is not any magic number that we are shooting for. We’re looking for overall improvement in the labor market

Too many commentators overreacted to what Bernanke said in June. The 7% unemployment rate number was treated as a trigger, not a threshold, even as Bernanke emphasized that it was the opposite. The unemployment rate was treated as the pivotal economic indicator influencing Fed decision-making. If you take a step back and look at the economic growth the past three months, there were few reasons the Fed would taper and many it wouldn’t.  The most important thing is that the economy underperformed Fed expectations. Yet, it was conventional wisdom that the taper was coming. That doesn’t mean Bernanke couldn’t have been clearer in June, but it means it was a fundamental misreading by journalists and investors. The Fed’s over-reliance on one economic indicator doesn’t change that.

The Fed’s Non-Taper Is All About Credibility

In a surprising move today, the Federal Reserve announced that it was not going to taper its bond-buying program. The Fed has been purchasing $85 billion worth of assets every month – $40 billion of mortgage-backed securities and $45 billion of long-term Treasuries. For months now, investors and journalists had expected the Fed to begin to decrease those amounts in today’s Federal Open Market Committee (FOMC) announcement. At 2 pm when the September FOMC statement came out, everyone was proven wrong:

 However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month

The stock market, bonds and gold all soared on the news of continued easy money while the dollar crashed. Why was everyone so sure that the Fed was prepared to taper today? It all goes back to the June FOMC meeting when Chairman Ben Bernanke first hinted at tapering. The Fed also upgraded its economic forecasts and in the press conference, Bernanke repeatedly emphasized the improvement in the labor market.

“If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year,” Bernanke said. “And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.”

Interest rates on the 10-year Treasury note skyrocketed while stocks and gold both fell. The market took it all to mean that easy money was coming to an end soon.

Except that wasn’t what Bernanke or the Fed was trying to say. They were trying to say that if economic data continues to come in positively, then the Fed will scale back its bond-buying program. But only if the economic data is good. From the June FOMC Statement:

The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.

If you read it literally, that statement clearly indicates that the Fed will react to labor market conditions in determining whether or not to taper. But the market parses every single word Bernanke says and it soon became conventional wisdom that a taper was coming. Dallas Fed Bank President Richard Fisher and Minnesota Fed President Narayana Kocherlakota both tried to walk back Bernanke’s statement and assert that a taper was not necessarily coming.

It didn’t matter.

But today, the Fed proved everyone wrong who parsed the statement and everyone right who read it literally. Subsequent jobs reports have been underwhelming, the Fed reduced its economic forecast today and the federal government is threatening to blow up the economy. If you listened to all of Bernanke’s comments and read the FOMC statement without overthinking it, you wouldn’t have been surprised by today’s announcement. The Fed said it would only begin tapering if the underlying economic data improved. But it worsened so the Fed shouldn’t have been expected to reduce its bond-buying. Yet, journalists and investors alike assumed that the Fed was still set on tapering, despite the underwhelming economic data.

With its announcement, the Fed was not trying to correct anything Bernanke said. It was trying to correct the market’s blind reading of the Fed’s statements. “Don’t just read that we’re going to taper. Read the caveats as well and take them into account.” Markets had assumed that when Bernanke mentioned tapering, it was set in stone that it would begin today. They did not believe for a second that poor economic data could delay it. Despite attempts to walk back Bernanke’s comments, the Fed could not credibly convince investors that it was not necessarily going to taper in September. By surprising the market and adjusting its policy based on labor market conditions, the Fed regained its credibility today.