THE FED PLAYS WITH FIRE ON JOBS / THE WALL STREET JOURNAL

Heard on the Street

The Fed Plays With Fire on Jobs

By Justin Lahart

Updated June 6, 2014 3:21 p.m. ET
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Workers on a Navistar truck assembly line in Ohio. Unemployment numbers likely understate the amount of slack in the job market. Joshua A. Bickel for The Wall Street Journal

The job market is in a very deep hole; financial markets have been gathering up kindling, and the Federal Reserve is going to have to make a difficult decision about which of these is worse.

The U.S. added 217,000 payrolls last month, the Labor Department reported Friday, finally pushing the total job count above the peak set in early 2008 as the economy entered recession. Yet since that time, the population ages 16 and over (and not in institutions like the armed forces, prisons or nursing homes) rose by about 15 million, many of whom would be working if given the opportunity. So the unemployment rate, at 6.3% versus 5% when the recession began, most likely understates the amount of slack in the economy.

Even if not, the Fed might have reason to worry. The peak in the unemployment rate following the 2001 recession was 6.3%, hit in June 2003. That was the month the Fed, citing the risk of deflation, cut its key interest-rate target to a 45-year low of 1% and was mapping out measures it might need to take to boost the economy further. It didn't begin lifting rates until a year later, when unemployment was at 5.6%.

The Fed didn't fully appreciate the damage financial-market distortions could inflict on the economy. Having learned this to great effect during the financial crisis, it cannot help but worry what problems may be getting sown now.

The combination of low market volatility and ultralow interest rates give investors an incentive to use borrowed money to buy risky assets. So far, that doesn't seem to be happening, but the Fed cannot know how long this will last. Nor can it know exactly what is happening in lightly regulated areas of the market. That argues for starting the process of raising short-term rates up from zero sooner rather than later.

Yet trying to stomp out the possibility of excessive risk-taking when there is still so much slack in the job market could also be dangerous.

First, it could push more people permanently out of the workforce, putting the economy on a lower growth path. Second, it could set back the day when wages are advancing quickly enough to push inflation, running at 1.4% excluding food and energy, to the 2% pace the Fed aims for. The employment cost index, a measure of total compensation the Fed watches closely, was up 1.8% in the first quarter from a year earlier. That is less than half its pace when the central bank began raising rates in 2004.

A slow expanding economy with little inflation is an economy at risk. When it slips into recession, the only way the central bank may be able to help is by taking rates down to zero and then adopting measures like the bond-buying program the Fed is now winding down. If it raises rates to curb speculative excess too soon, the Fed could find itself having to repeat the recent past to boost an economy in which incomes remain stuck in a rut.