Federal Reserve chairman Ben Bernanke is casting doubt on further substantial improvements in the U.S. employment picture, explaining the central bank's reluctance to declare the economic recovery is entrenched.
Speaking at an economics conference in Washington on Monday, Mr. Bernanke presented his most detailed argument to date for why U.S. interest rates must stay extremely low for another couple of years – even though the unemployment rate has dropped to 8.3 per cent in February from 8.9 per cent in October.
"Notwithstanding these welcome recent signs, the job market remains quite weak relative to historical norms," Mr. Bernanke said in prepared remarks.
"We cannot yet be sure that the recent pace of improvement in the labour market will be sustained," he added later.
Stock markets rallied Monday, as investors bet that the Fed will keep borrowing costs low and could even enhance its stimulus program.
In January, the Fed's policy committee voted to adopt a pledge to keep the official interest rate near zero until at least the end of 2014, so long as inflation remains timid.
Since then, however, economic indicators have been generally positive – employers, for example, have added about 245,000 jobs each month from December through February – creating an impression that the economy is stronger than the Fed assumed and suggesting that interest rates will be raised sooner than advertised.
The apparent disconnect is forcing Fed officials to explain more clearly why they remain glum about the positive news. Last week, New York Fed president William Dudley told an audience in Melville, N.Y., that he suspects the economy is getting a temporary boost from one of the warmest winters on record.
The pessimism of Mr. Bernanke and Mr. Dudley will mute expectations of higher interest rates, and keep alive speculation that policy makers will eventually deploy a third asset-purchase program, a strategy know as quantitative easing.
"We can conclude that QE3 … remains on the table as a possibility for later this year should growth fail to pick up," Nigel Gault, chief U.S. economist at IHS Global Insight, advised clients after Mr. Bernanke's speech on Monday.
The plunge in the U.S. unemployment rate troubles many economists because the drop defies a trusted link between hiring and changes in gross domestic product. For about five decades, Okun's law (named after American economist Arthur Okun) has held that an economy must grow at its non-inflationary potential to keep up with changes in population. So to lower the unemployment rate, an economy must exceed its potential for growth.
This hasn't happened in the United States. GDP was little changed in the first half of 2011, and only accelerated to an annual rate of growth of about 3 per cent in the fourth quarter.
Predicting the potential growth rate is inexact, but most at the Fed would say the U.S.'s rate is roughly 2.5 per cent a year. So if Okun's law still holds, then it will take many more quarters of growth at 3 per cent or more to lower the unemployment rate. The consensus at the Fed is for economic growth of 2.2 per cent to 2.7 per cent in 2012.
The surge of the unemployment rate to 10 per cent in 2009, from 4.9 per cent in 2008, was more extreme than Okun's law would have predicted. That suggests employers let go many workers from fear of what could happen, rather than entirely on the basis of lost demand.
Mr. Bernanke, a former professor at Princeton University, has a hypothesis for why the unemployment rate dropped so quickly, despite modest economic growth: the recent decline in the unemployment rate could represent a levelling of the original outsized increase in joblessness.
That's a positive. But if Mr. Bernanke is right, it means the traditional relationship between GDP growth and jobs could soon re-emerge. Unless growth speeds up from its current pace, this would mean the unemployment rate is about to level out at about 8 per cent, about three percentage points higher than the average over the 20 years preceding the recession.
To the extent that the change in the jobless rate is rebalancing the downsizing that occurred in 2009, "further significant improvements in the unemployment rate will likely require a more rapid expansion of production and demand from consumers and businesses, a process that can be supported by continued accommodative policies," Mr. Bernanke said.