Why the Fed might act (in one chart)

One bad jobs report is a blip. Three's a trend. And the United States has now seen three weak jobs reports in a row. Through the first quarter of 2012, the U.S. economy was creating an average of 226,000 jobs per month. In the second quarter? Just 75,000 jobs per month.

So what can be done about the sputtering economy? Congress could try to pass more stimulus. But Congress is deadlocked — Republicans are opposed to further action. That puts the spotlight on the Federal Reserve and Ben Bernanke. Right now, unemployment is falling more slowly than the Fed expected when it issued its forecasts back in April. Here's the chart, courtesy of the Council on Foreign Relations:

When the Fed published its forecasts, it expected more jobs reports like April's, which initially showed the economy adding 115,000 jobs new jobs. But that hasn't happened. Instead, April got revised downward. May added just 69,000 new jobs. And the June jobs report came in at just 80,000. That's well below the central bank's predictions. Which means the Fed's own numbers prove the Fed is failing to meet its dual mandate of keeping unemployment and inflation low. (Inflation is below the central bank's target right now; unemployment is not.)

That brings us to the next question. Does the Fed have any firepower left to jolt the labor market? Joseph Gagnon, who used to work on monetary policy at the Federal Reserve Board, thinks so. He lays out his recommendations in this primer for the Peterson Institute of International Economics:

The best option within the Fed’s legal authority is to announce a target range for the 30-year mortgage rate of 2.5 to 3 percent to be maintained for the next 12 months. This target would be enforced through unlimited purchases of MBS guaranteed by the federal housing agencies. The 12-month commitment would encourage banks to beef up their mortgage staffing and it would give potential homebuyers some assurance of the financing they could expect while they shop for a house.

This is similar to a program I outlined last fall. The Administration could help by forcing the housing agencies to stop dragging their feet on refinancing and loan modifications for underwater borrowers whose mortgages are already guaranteed by the agencies.

Although not a panacea, the above measures are substantial and would be viewed as such by market participants. The Fed could enhance their effects by stating clearly that a little more inflation would be welcome. A temporary increase of inflation to as much as 4 percent would be justified to the extent that it enabled a faster return to full employment. Raising expectations of future inflation moderately—in conjunction with a continued commitment to a near-zero policy rate—would lower the real interest rate, providing additional impetus to economic activity.

Gagnon goes through various objections to his proposal in the post, and he's not sure that these measures would be enough to get the U.S. economy back to full employment. But, he says, they would help quite a bit. And, right now, the labor market could use the lift.

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