Jobs and the Fed

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The labor market put in another strong showing in May. Nonfarm payroll jobs rose by a solid 248,000, the ninth monthly increase in a row. Upward revisions in the job numbers for March and April puts the job gain for the past three months at 947,000. Equally important, the employment growth has been widespread across industries. For the year so far, total nonfarm jobs are up an impressive 1.2 million. The labor market is warming, on it way to heating up.

Sustainability in job-market growth becomes more convincing when the manufacturing sector joins in. That has happened. After declining for more than three years, factory employment rose by 32,000 last month, the fourth rise in a row, and is up a healthy 91,000 since the beginning of the year.

The business cycle, with a boost from tax cuts, has at long last reached out to the job market, and hiring rates tell us that employers have come to believe that the recovery is deep-rooted and self-sustaining.

Civilian employment, as measured by household survey, also rose last month, by nearly 200,000, but growth in the labor force kept pace, so the unemployment rate remained unchanged at 5.6 percent. This is not surprising since an improvement in the job market often encourages people outside the labor force to actively look for work. For that reason, the jobless rate could temporarily continue to be sticky on the down side in the months ahead.

Although the unemployment rate failed to decline last month, the labor market nevertheless continued to tighten. When employment growth exceeds normal population additions to the labor force, unemployment in some form is drawn down. While the May increase in employment did not cut into unemployment as officially measured, i.e., reduce currently active job seekers, it did reduce the ranks of the "hidden" unemployed who are not included in the official definition of unemployment.

The job numbers weigh heavily in Federal Open Market Committee (FOMC) interest-rate decisions. The continued strength of payrolls and increased pressure on labor costs, together with other economic indicators, suggests that the FOMC will raise the federal funds target rate at its next meeting later this month. The consensus among Fed watchers is that the rate will be increased by 25 basis points, given the Committee's recent hints of a preference for gradualism, i.e., proceeding at a "measured" pace. But that small an increase could be a mistake.

The FOMC has already overinsured itself by lowering the federal funds rate to 1 percent, in part because of past fears of deflation. Given the current much improved state of the economy and the recent pickup in total and core inflation rates, a more neutral federal funds rate would be higher by the better part of a percentage point. The FOMC would do well to move up toward market rates of interest in order to better position itself to deal with further economic expansion, growing inflation pressures and expectations, and the possibility of unexpected shocks. Monetary policy lags are long and variable, and the economy shows no penchant for waiting.

So far in the current recovery the FOMC has had the luxury of wait-and-see before having to act. But that time has run out.

Besides slack resources, rapid productivity growth has been an important factor that has helped restrain inflation and give the FOMC more elbow room. Since the mid-1990s the trend in productivity growth has moved up a notch, mainly because of breakthroughs in information technology. But part of the productivity gain in recent quarters has been cyclical, and hence temporary, and can be expected to slow as the economy's excess capacity is drawn down. Consequently, the FOMC's decision space will narrow.

An increase of 50 basis points in the Federal Funds target rate this time around is in order, and if the economy continues to move briskly toward its potential non-inflationary growth path, another half point increase may be needed at the FOMC's meeting in August. Once the Fed Funds rate is in neutral territory, the committee can then proceed on its preferred path of raising rates in baby steps as conditions require. But better to get the bigger rate increases in place sooner rather than have to play catch-up in a later more fragile stage of economic expansion.

Alfred Tella is former Georgetown University research professor of economics.