The Federal Reserve has two mandates: keep prices stable and, within that boundary, promote full employment – which most economists target as a 4-5% unemployment, rather than 0%, which is usually regarded as an unattainable target. Generally speaking, the Federal Reserve can promote higher employment by making the price of expansion (i.e. borrowing money) easier and allowing an accommodative monetary policy. However, rapid employment expansion can increase competition for qualified employees, which requires employers to boost wages, increasing labor costs, and inflation. In other words, if employment gets TOO good, the Fed has to tighten up monetary policy to make sure that prices don’t skyrocket.
Let’s look at where we are today. After more than years of extremely accommodative policy, unemployment has fallen from about 10% to 5.4% in April 2015. That’s great news. The last time employment was this good was in May of 2008, when the employment rate was jumping from the pre-financial crisis rate of 4.5% to 5% to the 9-10% range of 2009. Before the crisis, the Federal Reserve rate was 5.25% through most of 2006 and 2007. For context, by May 2008 the Federal Reserve could already see the recession coming and had loosened the target rate to 2%. By the end of 2008, the effective Federal Reserve rate would be pretty close to 0%.
The point is that it took 16 months of loosening monetary policy for the Federal Reserve to cut rates from 5.25% to (essentially) 0%. Now that the economy has largely recovered (according to security prices, unemployment ranges) , there hasn’t been equal eagerness for increasing the Federal Reserve Rates. Already, the lackluster CPI and US GDP growth levels are giving the Fed room to delay the long-anticipated summer rate increase to the autumn. Our worry is that the SPEED at which the Fed will have to increase rates will necessarily increase the more they keep delaying the inevitable. After all, if there’s one thing markets prefer, it’s stability.