When Janet Yellen, the chair of the Federal Reserve, took the podium last Wednesday for her quarterly press conference, reporters repeatedly asked how the recent drop in oil prices—and subsequent fall in inflation—will affect the Fed’s policymaking. “Can you also speak to the downdraft we're seeing in inflation now?” the Wall Street Journal’s Jon Hilsenrath asked. A few minutes later, Steve Mufson, of the Washington Post, said, “I was just hoping you could go into a little more detail about the oil effect. Even though you see it as transitory, does that give you a little more room to keep rates low in the next few months?”
These questions hit on a major challenge facing Fed officials: The two economic statistics that they have historically relied upon—the inflation rate and unemployment rate—are no longer accurate indicators for the underlying state of the economy. How officials make policy in light of these developments will have a major impact on whether workers finally see their paychecks rise—or whether wages remain stagnant.
At some point in 2015, the Federal Reserve will end its zero interest rate policy, which it implemented in 2009 to boost the economy. When it decides to do so will have a significant effect on the recovery. Raise rates too soon, and the Fed could choke off the recovery before Americans see broad wage growth. Raise rates too late and modest inflation could result. To provide the market a sense of when the Fed will raise rates, Yellen, and before her Ben Bernanke, have stressed that Fed policy is data dependent—that is, economic statistics will guide monetary policy.
Historically, the two most important data points the Fed has used are the inflation rate and the unemployment rate. Economists believed that they functioned in an inverse relationship: push unemployment too low and inflation would rise; focus too hard on inflation and the economy would suffer. This is known as the Phillip’s Curve, and it was a key component for Fed officials in determining policy.
That’s why the recent drop in the price of oil has complicated the Fed’s decision making. In June and July, the spot price for crude oil peaked at more than $110. Over the next six months, the price crashed due to reduced demand from China and the Eurozone and OPEC’s decision not to cut back on supply. By the time Yellen began speaking Wednesday, the price hovered just above $60.
The fall in oil prices is good news for the economy since it will effectively act as a tax cut for millions of Americans. But it will also lower the headline inflation number that Fed economists have historically used to judge how fast prices are rising in the economy. The Commerce Department reported last week that the Consumer Price Index (CPI) fell 0.3 percent in November, for a year-over-year growth rate of 1.3 percent. For comparison, the CPI’s year-over-year growth in October was 1.7 percent.
The recent fall in inflation, though, does not represent a fall in the price level. Instead, it has been distorted by the changes in supply and demand for oil. Should the Fed still rely on this lower inflation number in its policymaking? Of course not. That’s why Yellen stressed at the press conference that the lower inflation numbers are “transitory” and the Fed would not adjust its policy in light of them. “Movements in oil, you know, are now down and perhaps later up, will move inflation around, certainly headline inflation,” she said. “But the committee at this point anticipates those impacts to be transitory. So as long as participants feel reasonably confident that the inflation projection is one where we expect to meet our 2 percent objective over time.”
The Fed faced a similar, though opposite, challenge when the price of oil spiked in 2011, causing inflation to rise. Some inflation hawks argued that the Fed needed to tighten policy in response. But Bernanke, then the Fed chair, responded that the changes in headline inflation were transitory and didn’t adjust policy. Not all central banks handled the rise in oil prices as smoothly. The European Central Bank, for instance, made a massive error when it prematurely raised interest rates in April 2011. That choked off the recovery in Eurozone countries and led to a double-dip recession. It was a stark warning that relying on faulty economic data for major policy decisions can lead to disastrous results.
The unemployment rate—technically known as the U3 measure—also poses a challenge for Fed officials, because it only includes those who are actively looking for work. People who are working part-time but want full-time work are excluded, as are discouraged workers that would reenter the labor market if the economy improves. That means the unemployment rate, which has fallen rapidly over the past year and is currently 5.8 percent, is not representative of the true slack in the labor market.
“The unemployment rate doesn’t tell you everything you need to know right now,” said Jared Bernstein, a senior fellow at the Center for Budget and Policy Priorities and the former chief economist for Vice President Joe Biden. “It is way too close right now to what most economists consider full employment given how much slack remains.”
This isn’t a new problem for the Fed. In fact, it’s slowly getting better. As the economy improves, more of those part-time workers will find full-time work and more of those discouraged workers will reenter the labor force, reducing the distortion in the unemployment rate. That’s represented in the labor force participation rate, which has stabilized in the past 18 months after continuously falling since the financial crisis. But that rate remains far below its pre-crisis peak, partially because Baby Boomers are retiring but also because millions of prime-age workers still haven’t rejoined the labor market. Whether those workers will start looking for a job again as the recovery continues is an open question—and only makes the Fed’s job more difficult.
Janet Yellen and other Federal Reserve Board members are well aware that the inflation rate and unemployment rate no longer provide a full picture of the state of the economy. For much of the year, Yellen stressed that the Fed was using a broad range of economic statistics—a “dashboard,” as she refers to them—in forming policy. That includes the inflation and unemployment rates but also a number of other indicators, like wage growth, GDP growth and the labor force participation rate. It also includes “core” inflation, which subtracts food and energy prices to provide a more stable statistic, and a broader measure of the unemployment rate, known as the U6, which captures part-time and discouraged workers. The Brookings Institute has created a continuously updated page for Yellen’s entire dashboard if you want to see them all.
This isn’t exactly new. The Fed has long considered other pieces of economic data beyond the inflation and unemployment rates in setting monetary policy. But this year, more than almost any in the past, has required Yellen and company to explicitly and repeatedly address the insufficiency of the inflation and unemployment rates. “We’re not going to look at any single indicator like the unemployment rate to assess how we’re doing on meeting our employment goal,” Yellen said in June. “We will look at a broad range of indicators.”
This has important implications on the paychecks of ordinary Americans. An over-reliance on the unemployment rate would lead the Fed to prematurely raise rates and stall the U.S. recovery. Yellen’s emphasis on other economic indicators has increased the chances that won’t happen, and low-income Americans should thank her for that.