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Here's When Unemployment Will Hit the Fed's New Target

Rick Newman

The unemployment rate has always been the most-watched economic indicator. It just got even more important.

In a major shift, the Federal Reserve has clarified the conditions under which it will rein in its aggressive monetary policy, a move that could push up interest rates and heavily impact financial markets once it happens. The Fed said it will keep its current policies of super-low short-term rates and "quantitative easing" in place until the unemployment rate drops to 6.5 percent, provided inflation doesn't rise above 2.5 percent.

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So the obvious question for investors and anybody interested in taking out a loan is, when will unemployment fall to 6.5 percent?

That target might not seem too far away, since the unemployment rate is now 7.7 percent, and it has come down by 1.3 percentage points over the last 15 months. If it kept falling at that rate, it might hit 6.5 percent by early 2014.

But most economists don't think that's likely to happen. Forecasting firm Macroeconomic Advisers, for instance, predicts the unemployment rate will still be at 7.3 percent at the end of 2014, which is as far out as its detailed forecasts go. Most other forecasting firms expect the same general trend, with the unemployment rate falling by only a few tenths of a percent per year, over the next several years. That means the rate might not fall to 6.5 percent until 2015 or even 2016.

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There are a couple of reasons unemployment is unlikely to improve expeditiously. First, most companies have already restaffed to the levels needed to fill holes left by big layoffs that occurred during the recession in 2008 and 2009. Future hiring will mostly be driven by a growth in sales and a need to hire workers in order to meet demand. With economic growth expected to be weak just about everywhere, sales at most companies will probably recover slowly.

The workers who are still unemployed will also probably have a harder time getting hired, because increasingly they tend to be people who have been out of work for a long time, with dated skills and rusty resumes.

Another factor is the typical pattern that occurs in labor markets as the economy recovers from a recession. Usually, the unemployment rate goes up during the early stages of a recovery, because people who gave up looking for work--and therefore weren't counted as unemployed--rejoin the labor force, which pushes up the unemployment rate temporarily. As long as the labor force is growing, that's typically a good sign, not a bad one. But the current recovery has been so uncharacteristically weak that we haven't even gotten to that point yet. So the unemployment rate may still need to rise a bit before it starts to decline in earnest.

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If unemployment doesn't fall to 6.5 percent until 2015 or later, that doesn't really alter the possible timing of the Fed's eventual monetary tightening, since the Fed has already said it will continue current policies until 2015 at the earliest. What the change does, however, is give financial markets a clear yardstick against which to measure progress toward the Fed's goal, instead of having to guess about what the Fed considers to be a sufficiently healthy job market. That ought to help improve the predictability of monetary policy.

As for inflation, many Fed critics are worried that it's on the way, because the Fed has essentially been printing a lot of money as part of its loose monetary policy. But inflation hasn't materialized yet--confounding a lot of Fed bashers--and mainstream forecasters don't see it arriving any time soon. Macroeconomic Adivsers' forecast calls for inflation well below 2 percent through the end of 2014, which would be within the Fed's parameters for continued easing.

A few things could change the whole outlook. If Washington politicians were able to negotiate major fiscal reforms in 2013, that could boost confidence while pushing growth higher than expected, and unemployment lower. On the other hand, a war with Iran or a fracture of the euro zone could spread gloom and make everything worse. It's a tricky world to predict. Even if you're the Fed.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.

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