Fed targets unemployment, but may be able to do little about it

That’s why the Federal Reserve, in a major departure from tradition, announced last week that it wants to see unemployment down to 6.5 percent, from the current 7.7 percent, before it starts raising interest rates.

The Fed hadn’t previously targeted the jobless rate, and for good reason: It has no control, and arguably not even much influence, over businesses’ hiring and firing decisions.

Supporters of the new unemployment target are hailing it as an advance in transparency.

Until last week, the Fed used the calendar to tell the markets when it might end this long, extraordinary period of zero interest rates. No rate increases before 2015, it had been saying. However, that date was always subject to change. Markets wanted to know more about the Fed’s thinking.

“Picking a calendar date never made sense,” says R.W. Hafer, a professor of economics at Southern Illinois University Edwardsville. “This at least has some link to their stated policy objectives.”

In the near future, the new policy will look a lot like the old one.

The Congressional Budget Office predicts that unemployment will hit about 6.5 percent in 2015, and Hafer says the Fed is probably looking at similar forecasts.

So, the unemployment target could be reached just about when the Fed was going to raise rates anyway. In fact, Fed Chairman Ben Bernanke took pains to emphasize that this was a change in the way the Fed communicates its policy, not a change in the policy itself.

Paul Edelstein, director of financial economics at IHS Global Insight, thinks the new target is an improvement.

“That date changed three times in a year,” he said. Now we have a marker. We know what to keep our eyes on.”

Targeting the jobless rate does carry some risk. In the 1970s, the Fed tried, and failed, to reduce unemployment, and in the process it allowed inflation to soar out of control.

The Fed says that won’t happen again; in fact, it says it will start raising rates if inflation is expected to go above 2.5 percent.

Allan Meltzer, a longtime historian of the Fed and a professor of political economy at Carnegie Mellon University, isn’t convinced.

“We’ll see if they pay any attention to the inflation caveat when they get there,” Meltzer said. “They’re already talking about relaxing it. ... When the inflation rate rises, history tells us they will be slow to respond.”

More fundamentally, Meltzer doesn’t think the Fed should be targeting a variable over which it has little control.

“It’s a mistake to mislead people,” Meltzer said. “Even more, I think they’re misleading themselves. If I listen to what many of them say, they seem to think they can do what they cannot do.”

In theory, low interest rates entice businesses to borrow money and launch expansion projects that would create jobs. Rates have been low for a long time, though, and banks have $1.4 trillion of excess reserves that they could turn into loans, but employers aren’t borrowing and aren’t hiring.

The average person on the street will probably be glad to hear that our central bankers care about unemployment, but he or she may be disheartened to know how little they can do about it.