Why the Unemployment Rate Doesn’t Matter to the Federal Reserve

Unemployment RateUnemployment numbers are the most eagerly anticipated data points in financial news, but the Federal Reserve doesn’t care as much as investors think. The decision to raise interest rates is a complex one, and Chairwoman Janet Yellen will consider a range of data on wage growth, labor force composition, and gross domestic product (GDP) growth.

The Fed will also think seriously about market expectations. The last thing they want is to incite panic by raising interest rates too quickly or by too much. After all, Wall Street is a fickle creature and can throw tantrums when its expectations are not met.

The most recent jobs report was released on Friday September 4th, and it showed 173,000 jobs were added in the economy. That’s a good thing, right? The labor force grew for the 60th consecutive month, lending at least some credibility to the narrative of an economic recovery.

Unfortunately, Wall Street doesn’t agree. Forecasters had estimated 220,000 new jobs for the month of August, and were disappointed when the numbers fell short. That’s why the stock market fell on Friday. At the time of writing, the S&P 500 and Dow Jones were down 1.5% and 1.75%, respectively. (Source: The Wall Street Journal, September 4, 2015.)

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Falling Unemployment isn’t the Whole Story

Wall Street’s reflexive pullback after the jobs report reveals a fatal flaw in their logic. If you consume a lot of financial news, you’ll be familiar with the phrase “earnings fell short of what analysts predicted” or “earnings missed expectations.”

Earnings missed expectations. Think about that: it’s not that forecasters misjudged what would happen, but that reality was somehow incorrect. Investors have bought into a linguistic trick that convinces us to use predictions as the yardstick for success.

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For instance, if a company’s profits exceed expectations, investors reward it with a higher share price because it feels as if something especially good has happened. That feeling tastes a lot like winning. And it can be addictive. After all, who doesn’t like being pleasantly surprised?

But that feeling can mislead us. Companies can restructure cash flows and defer tax liabilities to fatten their earnings in a period where expectations are high. Beating predictions becomes a game of short-term gains and clever accounting, while building a great company with long-term value becomes an outdated concept.

Likewise, conventional media sources will call this jobs report “underwhelming” or “weak.” But the unemployment rate just fell from 5.3% to 5.1% and I read that as a positive sign.

The Federal Reserve is Watching More Than Just Unemployment

To be clear, the 5.1% unemployment rate isn’t the happy beneficiary of rounding down. The official rate to two decimal points is 5.11%. Also, policymakers at the Fed know to take the 173,000 figure with a grain of salt.

The original numbers for June and July were revised to acknowledge 40,000 more jobs that weren’t initially counted. Figuring out what’s happening across the country, in real time, is a momentous task. There’s bound to be a margin of error.

Real GDP in the first quarter was originally thought to be slightly negative. Later in the year, we discovered the economy had actually grown during that period. There is a lag time between the on-the-ground reality and the numbers we see. So don’t put too much faith in first reports.

But even if the Federal Reserve did take the 173,000 at face value, it’s still a cause for optimism. The economy is improving, albeit marginally, and the Fed has continuously signalled a coming rate hike. In order to maintain credibility, they have little choice but to raise interest rates.

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