Last month, the U.S. Federal Reserve announced it would keep borrowing costs at rock bottom until unemployment drops to 6.5 per cent, provided inflation doesn’t rise past 2.5 per cent. It was a revolutionary statement. America’s monetary policy is now explicitly tied to the jobless rate, rather than just price levels. The Fed was administering the U.S. economy the equivalent of “a new drug that is yet to go through clinical testing,” wrote Mohamed El-Erian, the CEO of PIMCO, which runs the world’s largest bond fund.
The move raises a tough question: how long will it take to reach 6.5 per cent unemployment? It could happen as early as next year or as late as 2018, according to Michael Greenstone and Adam Looney at the Brookings Institution, a think tank based in Washington. Some observers are asking what Fed chairman Ben Bernanke will do if the jobless rate falls simply because more Americans give up looking for jobs, thus taking themselves out of the unemployment head count.
There’s also the question of the immediate health of the U.S. economy as it struggles with trillion-dollar deficits and debt ceilings that could send it back into recession this year. In the worst-case scenario, unemployment would climb back to nine per cent, up from 7.9 per cent now, according to the Congressional Budget Office. That would push a 6.5 per cent unemployment scenario even further into the future.
If it means many more years of near-zero interest rates, Bernanke’s medicine will have significant potential side effects. Such low-for-long rates discourage savings, hurt fixed-income investors like pension funds and insurance companies, and potentially invite very risky bets as people look for decent returns for their cash, says Beata Caranci, vice-president and deputy chief economist at TD Bank Financial Group.
Low rates south of the border would also constrain Canada’s ability to raise its own borrowing costs, something that Caranci says is essential in order to ensure that record levels of household debt don’t continue to grow. As long as borrowing costs next to nothing, people will take on more debt, she says. “It’s just economics.”