Fed's Interest Rate Policy Is Guided by Jobs, Not Inflation

Fed Chairman Ben Bernanke may no longer be worried about losing his job, but he’s still concerned about the job prospects of millions of other Americans.

Ben Bernanke

And until that changes, don’t expect any changes in the Fed's interest rate policy.

“That's their primary concern,” says Mickey Levy of Bank of America. “Getting to the point where the economic recovery is sustainable and jobs are a crucial element of that.”

Economists say recent comments from Fed officials—as well as central bank policy during past recessions—indicate as much.

“They have been very clear that the consumer is in very bad shape with high unemployment and tight credit,” says long-time Fed Watcher David Jones of DMJ Advisors,.

In its Nov 3-4 statement, the Fed's policy arm said: "Household spending appears to be expanding but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth.”

Jones expects something along those lines in the policy statement accompanying its decision Wednesday afternoon.

The words “slack” or “spare capacity,” often used in speeches by Fed officials, are other key qualifiers.

“One of the areas where we have the most spare capacity is the labor market.” Abby Joseph Cohen, chief equity strategist at Goldman Sachs, told CNBC. “The employment situation will take a long time to resolve. That being the case, Fed would like to keep rates a s low as possible as long as possible.”

Just how long depends on whom you ask. Jones says the first rate hike will come around mid-year, while Chris Rupkey of Bank of Tokyo-Mitsubishi says October 2010 is likely--a time range that covers the forecasts of many economists.

Rupkey points to the two previous recession-recovery periods wherein the Fed made its first rate hike about year after the jobless rate peaked. He suspects the peak will be around 10.2 percent, which is what the rate was in October 2009.

Between now and then, changes in the Fed’s description of the labor markets will set the table, as will what he calls “scattered payroll growth”  followed by the “first big number in job creation."

Following the 2001 recession the Fed remained worried about what many considered a jobless recovery up until mid 2004. In March of that year, the Fed's policy statement noted ”although job losses have slowed, new hiring has lagged."

It wasn’t until June 2004, when the Fed observed “that output is continuing to expand at a solid pace and labor market conditions have improved"—the economy had added 300,000-plus jobs in two of the three previous months — that it raised the fed funds rate for the first time.

That was exactly one year after payrolls had bottomed and the jobless rate peaked.

“They want to be reasonably convinced,” says Jones.

Given that jobless recoveries may now be deemed more of the norm than the exception, the Fed may need more convincing than usual, both for economic and political reasons.

“We still have quite a bit of recovery that needs to occur before the fed feels comfortable in raising interest rates in any meaningful way,” Goldman Sachs strategist Abbie Josep Cohen, told CNBC.

Economist note that other aspects of a typical recovery are either occurring at a retarded pace or lacking altogether. Lending and borrowing have been weak. Consumer spending has been even. The auto and housing sectors—leading indicators —are still struggling. 

Consumer spending has been erratic. The auto and housing sectors are still struggling. Lending and borrowing activity isn’t what it should be.

“Typically you have a correction in business inventories, followed by one by the consumer, “ says Jones.  “You have this smooth hand off that keeps recoveries sustainable—and that is what the Fed is looking for."

Fed Talks Tight, Walks Easy

Fed officials aren't the only ones looking; any number of Congressional critics and Obama administration officials—including the President himself—are looking over their shoulders.

“It’s become a political issue," says Rupkley. “The Fed chairman is very sensitive to that.”

Though you won’t find the issue in the minutes of any FOMC meeting, economists say it is clearly on the minds of voting members.

“The Fed is embattled and striving to maintain its independence,” says Levy. “An untimely premature move towards the Fed exit policy could just raise the ire of politicians.”

In that context, the tiny decline in November nonfarm payrolls—which could actually be a gain when revised data is released in January—may be the smallest of first steps.

“It looks like we're on the precipice of job growth,” says Robert Brusca of FAO Economics, who’s forecasting a solid recovery and job creation. “But if you don’t have a knock-your socks off number, then it doesn't look like you’ve turned the corner decisively.”

Especially, if re-election is around the corner.

Slideshow: States With The Highest Unemployment Rates