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(Reuters) - The Federal Reserve was reminded on Friday of the challenge of adopting numerical thresholds to guide expectations for future interest rate hikes, after the November jobless rate fell due to an unwelcome decline in the country's labor participation rate.
The U.S. central bank, which meets next week to review policy, is debating the merits of replacing a current pledge to hold interest rates near zero until at least mid-2015, with thresholds for unemployment and inflation.
But some Fed officials have warned that unemployment can drop for the "wrong" reasons. That argument was vindicated by data for last month showing unemployment declined to 7.7 percent after the labor force participation rate dipped to 63.6 percent as thousands of workers stopped looking for work.
It was a lowest unemployment reading in 4 years. But the underlying cause for the fall reinforced the message that labor market conditions remain tepid and well short of the substantial improvement the Fed wants to see before it starts raising rates.
Economists had not expected the Fed to reach a consensus on thresholds in time for its policy meeting on December 11 and December 12, which they think will be dominated by a decision to announce fresh purchases of Treasury bonds.
But they do think policymakers will talk about thresholds behind closed doors, as they review making a radical change to their communication strategy that would have major implication for how the Fed conducts monetary policy for the next several years.
"I don't think it makes it impossible for them to get there, but it definitely makes it harder," said Lewis Alexander at Nomura in New York.
Fed Chairman Ben Bernanke has recently highlighted a number of things he likes about thresholds, compared with the current date commitment, and his number two, Janet Yellen, says she is a stronger supporter of taking this step.
One proposal, put forward by Chicago Fed President Charles Evans, advocates holding rates low until unemployment reaches 6.5 percent, provided inflation stays under 2.5 percent. The Fed has a dual legal mandate to pursue both price stability and low unemployment.
Evans at one point had suggested 7.5 percent as a threshold, which might have made Friday's number look like a harbinger of policy tightening if it had been adopted.
But the minutes of the Fed's October meeting spelled out that although "many" policymakers thought thresholds could help the central bank communicate, the move remains a work in progress.
St. Louis Fed chief James Bullard, who is a voting member of the policy committee next year, has specifically noted that volatility in the participation rate can lead to changes in the unemployment rate that ought not signal a change in Fed policy.
"I think tying monetary policy explicitly to unemployment is a mistake. Unemployment tends to be a fickle variable," he told reporters after delivering a speech in Memphis in October. "Unemployment fell for wrong reasons... that kind of unemployment decline isn't going to make people very happy."
Threshold advocates at the Fed are well aware of this pitfall, and have sought to defuse it.
The Chicago Fed's Evans, an early and vocal proponent of thresholds, has repeatedly said that a drop in the unemployment rate is not the only thing the Fed will look at, even if it does adopt a specific unemployment-rate threshold.
Evans says he would also want to see above-trend GDP growth and at least 6 months of jobs gains of 200,000 or higher. By that measure, November's report falls short, with only 146,000 jobs created and the prior two months' totals revised down, underlining that the labor marker remains tepid.
Also, genuine improvement on the underlying health of the economy should deliver a pick-up in the participation rate in the longer run as workers who had become discouraged in their search for employment re-enter the workforce and find new jobs.
"If you think there is a cyclical decline in the participation rate, that should reverse itself as the economy heats up. So over the long run that (participation rate volatility) should all come out in the wash," said Michael Feroli at JP Morgan in New York.
Editing by Dan Grebler