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Eyeing 6.5% Unemployment, Fed Harks to First ‘Jobless Recovery’

Michael Santoli

The last time the U.S. economy met the conditions sketched out by the Federal Reserve as representing a return to some state of normalcy, "Schindler's List" won Best Picture, Wayne Gretzky set the career NHL scoring record, Congress voted against a balanced-budget amendment and David and Jerry's Guide to the World Wide Web was renamed Yahoo!

It was March 1994, and it was also the most recent month when the U.S. unemployment rate declined to 6.5% from above, the threshold the Fed set out yesterday as a prerequisite for when it might look to lift short-term interest rates from zero.

Before dropping to 6.5% in early 1994, the rate had peaked at 7.8% - quite close to today's 7.7% - in June 1992, just as Bill Clinton was building to a lead in the presidential campaign with his "It's the economy, stupid" mantra. The early '90s recession, though shallow, gave way to what became the first "jobless recovery."

The Fed had begun cutting short-term interest rates in mid-1990 from the now-unthinkable level of 8.25% to 3% by September 1992. They remained there until February 1994, when Fed Chairman Alan Greenspan responded to gathering inflationary pressures by imposing a surprise rate boost.

The move gutted the bond market and was considered risky at the time, given how fragile the recovery seemed. As it happened, we now know that the tailwinds of fortune were already following the economy, with cheap energy, globalizing markets, the tech revolution and easy credit carrying America to a booming, and eventual bubble-beset, decade.

That the Fed now is implicitly casting 6.5% as the minimal standard for considering the end to its urgent, emergency-level monetary stimulus efforts tells us something about how impaired the economy became in the credit bust and how high its tolerance for the medicine of liquidity has gotten. The relatively mild recession of the early 2000s never produced a rate that high -- unemployment peaked at 6.3% before grudgingly declining in the middle of the decade, abetted by short rates below 2%, a credit-and-housing boom and growing federal deficits.

Another way to think about the 6.5% unemployment level is that it has more recently marked the border between crisis conditions and a simply weak economy. The rate jumped to 6.5% from 6.1% in one month from September to October 2008, just as Lehman Brothers failed and the economy morphed from mere recession into full-blown financial panic.

From this angle, then, the economy will only have undone the damage to the job market from the crisis phase of the Great Recession once unemployment is forced down another 1.2 percentage points or so.

Fed policy makers did not present the 6.5% guidepost in these terms, but instead pointed to its baseline forecast for the (admittedly grudging) pace of employment growth in coming years. Its standing expectation is and has been that unemployment could decline to 6.8% by the end of 2014 or so, with an improvement to or below 6.5% some time in 2015.

So the new 6.5% target fits the Fed's prior guidance that the zero-rate policy will remain at least until mid-2015, making it more a restatement of the existing "low for long" message on rates than a new formula for driving policy. There has been some chatter that framing the outlook in terms of tracking the economy's recovery, using sliding unemployment rates, is a more hopeful approach than simply reminding investors and consumers that we will be ailing and in need of free money for the foreseeable future.

There's something to that, even if it's largely semantics. If the early 1994 example has anything to tell us today, it is that 6.5% unemployment only feels OK when it has recently been much higher — and that it is at least possible for forecasts of job growth during a slow recovery to be insufficiently optimistic.