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Apart from the all important decision on QE tapering, the Fed could also consider changing the thresholds for keeping the interest rate at exceptionally low levels. The Fed’s unemployment threshold (not an automatic trigger), is 6.5%, and was set in December 2012. At the time, the unemployment rate was 7.7% (for November 2012) and the participation rate was at 63.6%.

Since then, the unemployment rate fell to 7% (in November 2013), but this is also owed to a drop in the participation rate, to 63.0%. Fed Chairman Ben Bernanke has often stated that the unemployment rate overstates the real picture of the labor market. So, will the Fed lower the unemployment rate threshold? The chances are low, and the answer is not related at all to the question of credibility.

Changing forward guidance is seen by some as a move that will undermine the Fed’s credibility: if you change the goal, what is it worth? Forward guidance is based on trust and credibility. However, there is also a flip side: adjusting to changing conditions strengthens the credibility. In general, the Federal Reserve is a very credibly institution.

So, if the credibility argument is not really relevant, why will the drop in the participation rate not play a role this time?

The answer comes from the Fed as well. A study published by  Shigeru Fujita of the  Federal Reserve Bank of Philadelphia concludes that (page 7):

the  decline in the participation rate in the last one-and-a-half years (when the unemployment rate  declined faster than expected) is entirely due to retirement.

So, if the fall is due to the natural retirement of workers rather than discouragement, the unemployment rate is now more credible. And will this change? According to the study, probably not. Here is another quote from the study, which addresses the issue of discouragement to search for a job (emphasis mine):

There is no question that more workers dropped out of the labor force due to discouragement during and after the Great Recession and that there are more discouraged workers now than before the recession. These facts clearly reflect the continued weakness of the U.S. labor market. However, it is not clear whether the overall participation rate will increase any time soon, given that the underlying downward trend due to retirement is likely to continue.

So, the current trend is likely to continue, and is a natural change rather than a “cyclical” change and changing the threshold to adapt to the fall in the unemployment rate is not warranted.

Further reading:  US core inflation remains healthy at 1.7% – no hurdle for QE tapering

Thanks to Mish for highlighting this study.

In addition, here are 11 reasons for QE tapering in December.