Unemployment falling for wrong reason creates Fed predicament

The good news may be bad news for the Federal Reserve as it considers when to begin scaling back its stimulus.

While unemployment dropped last month to 7.3%, the lowest level since December 2008, the decline occurred because of contraction in the workforce, not because more people got jobs. Labor-force participation -- the share of working-age people either holding a job or looking for one -- stands at a 35-year low.

The reduced workforce “poses a problem for the Fed,” said Roberto Perli, a former central bank official who is now a partner at Cornerstone Macro LP in Washington. “The unemployment rate is coming down faster than the Fed thought, but it’s not declining for the right reason.”

The jobless rate is important because Chairman Ben S. Bernanke and his colleagues have established it as the lodestar for policy. Bernanke has said he expects the Fed to complete its asset-purchase program in the middle of next year when unemployment is around 7%.

So long as inflation remains contained, the central bank has said it won’t even consider raising its benchmark interest rate until unemployment falls to 6.5%. The Fed cut its target for the overnight interbank rate effectively to zero in December 2008 and has held it at that record low.

A key question facing policy makers is how much of the decline in the participation rate is structural and long-lasting and how much is cyclical and temporary.

Boomers Retiring

If the drop is mainly driven by demographics -- aging baby boomers retiring -- then the lower unemployment rate gives a true picture of the amount of slack left in the labor market. If the contraction instead is caused by discouraged job-seekers giving up their search, then the jobless rate doesn’t reflect the true state of the market.

Both alternatives have implications for bond investors. A quicker swing from stimulus to austerity by the Fed would push up yields on Treasury securities. John Herrmann, director of U.S. rate strategy at Mitsubishi UFJ Securities USA Inc. in New York, forecasts the yield on the 10-year Treasury note will rise to 3.25% by the end of this year as the jobs market strengthens. It was 2.93% at 4 p.m. in New York on Sept. 6, according to Bloomberg Bond Trader data.

Since hitting a 26-year high of 10% in October 2009, the unemployment rate has fallen 2.7 percentage points, according to the Labor Department in Washington. A big portion of that decline -- 1.8 points -- was because of a drop in labor- force participation to 63.2%.

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