Will job numbers make the Fed hit the brakes?

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The latest monthly U.S. employment numbers, set for release Friday, provide a fresh gauge on the U.S. march toward 6.5-per-cent unemployment – the level at which the Federal Reserve Board has said it would start considering raising its near-zero policy interest rate. With the markets hyper-sensitive to the question of when the Fed will start reversing its unprecedentedly accommodative monetary policies (starting with an anticipated "tapering" of quantitative easing, a precursor to eventual rate hikes), any above-estimate job growth or below-estimate unemployment rate would kick off hand-wringing that the Fed is on a fast track to monetary tightening.

Don't count on it. The Fed's stated mandate on the labour front is to "maximize employment" – and even if the U.S. is closing in on the magic 6.5-per-cent unemployment number, employment is a long, long way from maximized. The improving numbers mask a troubling near-total lack of recovery in labour-force participation. A lot of people left the U.S. labour force outright in the Great Recession – not even trying to find a job any more – and they haven't come back.

In a report this week, Montreal-based independent economic research firm BCA Research noted that despite unemployment having fallen from 10 per cent at its 2009 peak to 7.5 per cent as of April, the employment-to-population ratio for adults age 25 to 54 is still 4.5 percentage points less than its pre-recession average. What's more, these participation levels have shown little improvement since the end of the recession.

It should be noted that the Fed never said it would raise rates once unemployment fell to 6.5 per cent (which is on pace to happen some time next year). It only said it would keep its key Fed funds rate at current lows "at least as long as the unemployment rate remains above 6.5 per cent." Which means it would only consider starting to raise rates once that criterion has been met. BCA believes that upon such consideration, the Fed will reject rate hikes as premature – because hikes could kill any chance of a full recovery in labour participation.

"Recent research by the Fed suggests that the participation rate tends to react quite slowly to improvements in labour market conditions, and that the longer the participation rate remains depressed, the greater the risk that a worker will permanently drop out of the labour force," it wrote.

"This provides the Fed justification for taking measures to 'overheat' the labour market – that is, to bring down the unemployment rate below where it was before the recession – in order to draw more people into the workforce, and by so doing, to maximize the long-term level of employment, as the Fed's mandate requires."

Indeed, BCA noted, this approach is implied by the "optimal control" approach to rate policy laid out in a speech last year by Fed vice-chairman Janet Yellen – who is considered the front-runner to succeed Ben Bernanke as chairman when his term ends about eight months from now. Under this approach, the Fed funds rate wouldn't start to rise until late 2015, by which time unemployment would be well below 6 per cent. (Inflation under this scenario would creep above the Fed's favoured 2-per-cent target, but not dramatically.)

"We continue to believe the odds are low of premature easing at the Fed, especially since core inflation is so low," BCA concluded.

Still, the financial markets may not agree – creating the possibility of a dramatic reaction to Friday's job numbers, as the debate over the timing of QE tapering remains a major preoccupation. In fact, Merrill Lynch chief investment strategist Michael Hartnett noted in a report Thursday, it's being seen in some quarters as "the most important payroll release in years," coming after a month in which QE worries wreaked havoc on the bond market.

Mr. Hartnett believes that a job-growth number north of 250,000 (versus the consensus estimate of 165,000) would be needed to send the market's into a new tizzy, as that kind of number would imply an "imminent" unwinding of QE. On the other hand, he said, a figure below 90,000 would suggest to the markets that QE will be around longer than expected, reversing the recent bond sell-off.