Today, Federal Reserve Board Chair Janet Yellen will go before Congress to report on the economy and monetary policy. A key topic of discussion will be the Fed's decision in December to raise the federal funds interest rate by one-quarter of a percentage point. This was the first time that the Fed had raised interest rates since the beginning of the recession in December 2007.
The Fed has a dual mandate to constrain inflation and maximize employment. The Fed has interpreted the inflation side of this mandate as meaning that it should try to have an average annual inflation rate of 2 percent. In balancing these goals, the Fed raises rates when it wants to push down inflation at the cost of lowering employment; when the Fed wants to raise employment at the cost of higher inflation, it lowers rates.
This made the Fed's decision to raise interest rates puzzling. Given that inflation has been running below the Fed's 2 percent target for 15 straight quarters (nearly four years), the Fed should've been pursuing higher rather than lower inflation. Last quarter's 1.2 percent annualized inflation rate is far short of the Fed's 2 percent target.
The only statistical measure consistent with the Fed's decision is the unemployment rate, which seems to be signaling a strong labor market. As of January, the unemployment rate stood at 4.9 percent, just slightly higher than the 2007 rate of 4.6 percent. However, the unemployment rate is an imperfect measure of the strength of the economy: In order to be counted as unemployed, a prospective worker must have actively looked for work in the prior four weeks. This means that if the economy weakens and a large number of discouraged job-seekers give up the search for work, the unemployment rate actually falls.
The easiest way to correct for this problem is to look at rates of employment rather than unemployment. And the employment rate tells a far more pessimistic story, having fallen substantially below its pre-recession level. Moreover, this clearly isn't just a story of an aging population: The employment rate of 25-to-54-year-olds fell 4.8 percentage points during the downturn and has only recovered 2.8 percentage points since then. This means that over six years after the end of the recession, the labor market is still less than three-fifths recovered. If we continue making up ground at the same pace as since the beginning of the recovery, we won't fully recover until 2019.
Other signals of labor market weakness also show that the unemployment rate is painting an inaccurate picture of the economy. Along with our nation's 8 million unemployed workers, there are another 6 million workers who aren't classified as unemployed but say they want a job; and there are yet another 6 million workers who find themselves involuntarily working part-time. Both those figures are much higher than we should expect given 4.9 percent unemployment. When we adjust the unemployment rate for today's abnormally high numbers of discouraged workers, involuntary part-time workers and long-term unemployed workers, we see that the unemployment rate should undoubtedly be much higher. In fact, if no 25-to-54-year-olds had given up the search for work, last month's unemployment rate would've been 6.3 percent.
According to both of the Fed's goals — a strong labor market and 2 percent inflation — it was a mistake to raise rates in December. If the Fed could have foreseen the slow growth and weak job gains from the months following its announcement, it obviously would've held off on raising rates. It should at least not compound this mistake with further hikes in coming months, and it should leave open the option of reversing course and lowering rates again.
Buffie is a researcher at the Center for Economic and Policy Research.