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Why a rising unemployment rate will be good for Yellen

Amid a slew of data this week, the best report for Janet Yellen and the doves on the Fed could be a rising unemployment rate.

It sounds harsh, but under the right circumstances, Yellen could welcome a rise in joblessness as proof that her theory of the labor marketthat there's lots of extra workers out thereis accurate. This would confirm the Fed's still wide-open stance on monetary policy that has many on Wall Street forecasting no rate hikes until mid next year, and then only gently.

But a faster pace of change in any of the key market indicators that Yellen watches could prompt the Fed to faster rate hikes. "Right now, we're in the view of the summer time (2015)" for the first rate hike, said JP Morgan Chief Economist Mike Feroli. "But the most questions we're getting are whether it could be earlier. People have their eye on the March meeting."

An employee checks labels of "Naranja Agria" (Sour Orange Marinade) on the bottling line at the Badia Spices factory in Doral, Florida, Aug. 19, 2014.
Mark Elias | Bloomberg | Getty Images
An employee checks labels of "Naranja Agria" (Sour Orange Marinade) on the bottling line at the Badia Spices factory in Doral, Florida, Aug. 19, 2014.

The Fed funds futures markets for December 2015, looks for a rate of just 72 basis points, which means the market is even discounting the Fed's own average forecast of around 1.2 percent. "The risk is that we could see more rate hikes than the market is currently anticipating," Feroli said.

The proverbial Goldilocks "just right" jobs report this Friday would be a repeat of last month. In August, 209,000 jobs were created, but 329,000 more Americans entered (or in some cases reentered) the workforce. The result was to drive up the unemployment rate by a tenth.

Read MoreUS manufacturing soars to 3-year high; construction spending jumps

Yellen, of course, would be more than happy if all job seekers found work. But her current policy outlook seems based on the scenario where a strong job market brings people off of the sidelines in fairly large numbers. The result would be an unemployment rate that wiggles around the current 6.2 percent as not everyone who wants a job finds one in the month when they start looking, but the U.S. still produces more than 200,000 jobs a month.

The participation rate has clearly stopped declining since bottoming out at 62.8 percent in April. It actually ticked up a tenth last month. That will be something worth watching this Friday, with the understanding that the labor force is a highly volatile number that can go up by half a million one month and down 800,000, as it did in March and April this year. Yellen has argued that a meaningful part of the decline in the participation rate comes from people dropping out of the workforce because they are discouraged by the job market, and from early retirements and people going back to school. In Jackson Hole, Yellen suggested some of this could reverse.

Week ahead in econ

    Est.
Thu ADP 215k
Thu Jobless claims 300k
Fri Nonfarm payrolls 220k
Fri Unemployment rate 6.1%
Fri Avg. hourly wage 0.2%

"The rapid pace of retirements over the past few years might reflect some degree of pull-forward of future retirements in the face of a weak labor market,'' she said. "If so, retirements might contribute less to declining participation in the period ahead than would otherwise be expected based on the aging workforce.''

Read MoreUS factory activity expands in August at fastest pace since April 2010: Markit

Wages are another area to focus on. They have grown a relatively weak 2 percent year-over-year, and Yellen also thinks that the large number of people who could reenter the workforce should put downward pressure on wages. Some of the long-term unemployed theoretically should be willing to return to work at lower wages than they had previously earned. Wage pressure is also kept down by people being hired into low-wage industries.

A new indicator being worked on at the Kansas City Federal Reserve attempts to put together all the different labor market indicators. The measure of 24 different data points includes how many people are being hired, how many are leaving their jobs, how many claim unemployment insurance and what consumers expect in the job market, among many others. The so-called Labor Market Conditions Index or LMCI, has ticked up pretty steadily since 2010, but remains below the average level since 1992. In fact, it's below the worst levels reached in the 1992 and 2001 recessions.

Economists at the Kansas City Fed project the current momentum won't put the index back to its average until the second half of 2015, which coincides with the market's view of when the Fed will start raising rates.

—By CNBC's Steve Liesman

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