Much Ado About Inflation


How a 6.3% unemployment rate could mean the Fed’s days of doing their best Fat Joe impression could be coming to an end.  



To some economists a 6.5% unemployment rate is something that is an important factor when it comes to interest rates.


Let me explain.


Ever since the 2008 recession, the Federal Reserve has desperately tried to fend off a slumping economy. The Fed’s answer to this was to create a stimulus that would kick start an economic recovery (i.e create liquidity through low credit rates). As you may have guessed, this rubbed the deficit hawks the wrong way. To them, the Fed’s primary purpose is to make sure that inflation is low as possible and by keeping interest rates that low, many of them worry all it does is create cheap capital which attracts bad ventures. Thus creating inflation.


Now during this recovery period, the deficit hawks became the minority within the Fed, with many of them being called “obsessives” for focusing on a single piece of the puzzle (inflation) and not looking at the larger picture (the overall recovery of the US economy). People like Nobel Prize winning economist Paul Krugman even called them out in various op-ed pieces like this one.


Ok, back to why 6.5% unemployment rate is important.


After the 2008 Recession hit, the Fed set a threshold of 6.5% unemployment rate believing if the jobless rate was over this percentage, then the economy was still in recovery mode. In other words, up until it drops below that threshold, the Fed wants to keep interest rates low. But that’s not the only significance with a 6.5% unemployment rate.


As this fancy chart below shows, once the unemployment rate gets below 6.5%, things get a little unpredictable when it comes to inflation.


This inflation chart be bananas YO!

Oh inflation, you crazy bastard!


The chart is from a study done by Kevin Logan, chief US economist for HSBC financial services. He found that, aside from two outliers, inflation declined when unemployment was above 6.5%. But when unemployment levels reach below 6.5%, well your guess on where inflation will go is as good as ours. It becomes completely unpredictable.


While despite the skewed predictions of the US economy going back to the good ole’ days where even your dog was qualifying for a home loan from banks, the recovery hasn’t been as much of a downer as people are making it out to be. In this month’s labor report, it was said that the US economy had added 288,000 jobs in the month of April with an unemployment rate dropping to 6.3%. Granted that the long term unemployed has reached to 3.5 million, but in the big picture things are still moving in an upward momentum. Which is good. Still the question presides.


What does the Fed do now that unemployment rate has reached below 6.5%?


Well… good question.


Because the economy definitely hasn’t fully recovered yet and there are some that even believe unemployment rate should reach as low as 5.5% before anything is done with interest rates, everyone can agree that keeping interest rates this low for this long is in many ways flirting with danger.


Fiscal conservatives and deficit hawks have been on the losing end of many economic battles as of late when it comes to public policy. For once they seem to have a powerful ally in the Fed. But whether they are on the winning side, only more time can answer that one.


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