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Why a Drop in the Unemployment Rate Could Be Bad News

Rick Newman
Senior Columnist
The Exchange
In this photo made Danny Newell, an unemployed former logger, hangs out at his home Wednesday, Oct. 2, 2013, in Indian Township, Maine. The latest figures from the federal Bureau of Indian Affairs put unemployment on the Passamaquoddy reservation at an astonishing 60 percent, causing an exodus of tribal members. (AP Photo/Robert F. Bukaty)

The new year could kick off with some good news that isn’t really good news — a sharp drop in the unemployment rate that might hurt the economy more than it helps.

The drop would occur if Congress chooses not to renew extended unemployment benefits at the end of the year, which would cost taxpayers about $19 billion in 2014. Given the ongoing scarcity of jobs — especially ones that pay well — those benefits are a lifeline for a lot of people who have been unemployed more than a few months. But the pressure is on in Washington to rein in spending and wind down stimulus measures that date back to 2009. So federal unemployment benefits look endangered.

If those benefits end, it could mean a big change to the numbers that determine the unemployment rate, which is nothing more than the number of people who don’t have jobs and are looking for work, as a percentage of the total labor force. The latest numbers, for instance, show there are 11,272,000 unemployed people, out of a total labor force of 154,839,000. Here’s the equation that determines the unemployment rate: 11,272,000 ÷154,839,000 = 7.3%.

If those 1.3 million people likely to stop getting federal benefits all continued to look for work, it wouldn’t affect the unemployment rate, because they would still be counted as unemployed. But that’s not what economists think will happen.

No longer employable?

“Their skills have deteriorated to such an extent that they are not employable,” writes Jeffrey Rosen, chief economist for Briefing.com. “Once the unemployment benefits end, there will be nothing to connect these long-term unemployed to the labor force.”

People who lose their jobs and stop looking for work are no longer counted as unemployed or as members of the labor force. So if everybody getting those federal benefits dropped out of the labor force, you'd subtract 1.3 million from both numbers in the equation above and the unemployment rate would suddenly drop to 6.5%.

That’s a rather important number, because the Federal Reserve has said a 6.5% unemployment rate might signal enough improvement in the economy that it could tighten its easy-money policies and start raising interest rates. Of course, that 0.8 percentage point drop would be nothing more than a statistical anomaly reflecting no real improvement whatsoever in the job market. In fact, the Congressional Budget Office estimates that extending the benefits throughout 2014 would boost employment by about 200,000, through higher spending by people receiving the money. So axing the program for good would actually cost the economy jobs and depress GDP growth slightly.

If Congress does cut off those benefits, some of the 1.3 million recipients will probably keep looking for jobs, and some of those will find work eventually. So the unemploument rate probably won't hit 6.5% anytime soon. Still, it could quickly drop below 7%, with people who give up on work leaning more heavily on family members, applying for disability benefits or falling deeply into poverty. That has already been happening to some extent, which is one reason the percentage of the adult population working or looking for work has hit the lowest level since 1978.

If unemployment does suddenly approach 6.5%, the Fed will almost certainly change its threshold for raising interest rates, since it has also issued firm guidance indicating that rate hikes aren’t likely until 2015 at the earliest. Options include lowering the threshold rate of unemployment (an option reportedly being debated by Fed members), switching to a less volatile indicator such as the employment-population ratio, or ditching the idea of thresholds altogether. Keep in mind that hitting 6.5% is not in any way an automatic trigger to lower rates but simply a "key" to an eventual return to more-normalized rates.

Still, if the unemployment rate suddenly nears that threshold, financial markets may have to adjust as well, since investors and business leaders regard the unemployment rate as one of the key indicators helping them gauge where the economy is headed.

It won’t be the first time something that seems like good news turns out not to be.

Rick Newman’s latest book is Rebounders: How Winners Pivot From Setback To Success . Follow him on Twitter: @rickjnewman .