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Why higher interest rates won't stall U.S. job growth

July 5, 2013: 8:44 AM ET

As long as interest rates rise on positive economic news, as opposed to bad news, the economy will continue creating jobs at a decent pace.

<> on December 7, 2012 in San Francisco, United States.FORTUNE -- The U.S. economy created 195,000 jobs in June, more than most expected. The number of jobs created in April in May were revised upward, and the unemployment rate stayed at 7.6%.

The question now is will the economy continue creating jobs at a decent clip, particularly as the U.S. enters a new era of higher interest rates? If that happens, it would raise borrowing costs for everything from buying a home to investing in new office buildings and equipment at a time when the economy, while improving, is still relatively fragile.

Frustrated with the economy's slow recovery from recession, the U.S. Federal Reserve has kept interest rates near zero since 2008. It is currently buying $85 billion in Treasury and mortgage bonds each month, and Fed Chairman Ben Bernanke spooked markets when he hinted in May that the central bank could slow down its quantitative easing program this year. He reiterated the point last month, adding that the Fed could stop asset purchases altogether by mid-2014 so long as the economy improves as expected.

The news has caused a sharp selloff in markets globally; investors wonder if less support from the Fed could really hurt the economy. Since May, the yield on the 10-year Treasury note has surged from 1.64% to a peak of 2.6% before slipping slightly to 2.5% Wednesday. And on Friday, following release of June's jobs report, a selloff sent the 10-year note's yield higher, touching 2.719% -- its highest level since 2.858% on August 1, 2011.

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While the Fed's remarks have pushed interest rates higher, the rise also reflects good economic news as more Americans find jobs and buy homes. Investors have sold off bonds for riskier stocks and commodities; home prices have risen. Even if interest rates go up some more, it likely won't dampen job creation, just as it hasn't during the past several months, says Paul Edelstein, economist with IHS Global Insight.

Since just before the Fed launched its third round of quantitative easing in September, the interest rate on the 10-year note has risen steadily. During that period, the economy created 1.7 million jobs, translating to an average of about 190,000 jobs a month on average, Edelstein notes.

That's not great; it's not enough to make up for the millions of jobs lost during the 2007-2008 financial crisis. Compared to previous recoveries, this one is still pretty tepid: The share of the population in the labor force, or the labor participation rate, remains at historic lows. So has the share of the population with jobs, called the employment-to-population rate, which stood at 58.7%.

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Nonetheless, the pace of job growth has been enough to keep up with the nation's growing population. More than that, the rise in mortgage rates hasn't derailed the recovery of the housing market. This says a lot about the overall economy, since the vast majority of Americans' wealth is tied closely to the homes they own.

To be sure, the increase in mortgage rates has hurt applications for refinancing, which tumbled by 29.5% during June, according to Capital Economics. Mortgage applications for home purchases, which are a better measure of the housing market's underlying demand, edged up by 0.1% in June from the previous month and are up 12.3% from a year earlier.

The Fed now predicts unemployment will fall to 7.2% or 7.3% at the end of 2013 from 7.6% now. True, the central bank has previously been guilty of being too optimistic about the economy. If the Fed pulls out of its asset purchases too soon and causes rates to move to 3% later this year, that could very well derail the recovery, Edelstein says. But so long as interest rates rise on positive economic news, as opposed to bad news, the economy will continue creating jobs at a decent pace.

"The fact that the 10-year note is not at 1% is a good thing," he adds.

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About This Author
Nin-Hai Tseng
Nin-Hai Tseng
Writer, Fortune

Nin-Hai Tseng covers economics and finance. Before joining Fortune, Tseng was a reporter at The Orlando Sentinel and a public affairs associate at GE. She holds an MPA from Columbia University and a BS in Journalism from the University of Florida. She lives in New York City.

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