Shifting Jobless Outlook Puts Fed in Risky Territory

(Bloomberg) — Janet Yellen’s Federal Reserve is rethinking how far it can let unemployment fall before inflation kicks in. It’s a call fraught with risk, and history offers few guideposts.

Millions of workers on the sidelines and shifting demographics make it harder to tell just how low the jobless rate can sink before labor supply gets tight enough to stoke wage and price pressures.

It’s a key issue for Fed officials debating when to lift interest rates. Policy makers indicated earlier this month they see room for more improvement in the job market. They marked down their projection of long-term unemployment to as low as 5 percent from the 5.2 percent to 5.5 percent range they saw in December.

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Now, some economists are asking whether the Fed has overshot, while others wonder if policy makers should aim to get unemployment even lower.

“The goalposts are moving on their own, and the Fed is trying to figure out where they are,” said Michael Hanson, senior U.S. economist at Bank of America Merrill Lynch in New York. Because policy works with a lag, he said, officials are forced to rely on today’s projections as they shape tomorrow’s outcomes. “They’re trying to drive a car looking in the rear-view mirror.”

Disagreement abounds, and the stakes for predicting long-run unemployment are high.

Fed’s Groping

“Nobody really knows that number with any precision,” former Fed Chairman Ben S. Bernanke said at a conference in Washington Monday. “The Fed will continue to grope to find out what the right number is.”

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If the Fed is overly ambitious about how low unemployment can sink, policy makers could wait too long to increase interest rates and let inflation heat up more than they intend, repeating missteps from the 1970s. If they raise rates too soon or too high, though, they could needlessly put a lid on the U.S. expansion.

The Fed monitors labor and inflation data to predict one policy guidepost, known as the non-accelerating inflation rate of unemployment. The so-called NAIRU is roughly synonymous with the natural rate of unemployment: the joblessness that exists even in a healthy economy, as industries evolve, creating some jobs and wiping out others. Pushing unemployment below that equilibrium rate tightens the labor market past a tipping point, prompting employers to offer higher wages. That in turn boosts prices.

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After the onset of the 2007-2009 recession, economists expected that the natural rate had probably shifted higher: Many Americans had been out of work for months or years, long enough for their skills to atrophy and leave them permanently jobless. Technology seemed to be causing an unprecedented skills mismatch.

Millennial Generation

What’s more, demographics could be expected to push natural unemployment higher. People in the large Baby Boom generation are aging out of their prime working years and into retirement. That means the bulk of the labor force is shifting toward the even-larger Millennial generation, born after 1981. Because younger workers tend to have fewer work skills and higher unemployment, their workforce dominance could push up overall jobless levels.

Amid such structural changes, the Fed’s forecast of long-term unemployment rose to a range of 5.2 percent to 6 percent in 2012 and 2013.

With fewer experienced, skilled workers in the labor force, a drop in headline unemployment would be expected to force employers to offer higher wages to attract qualified applicants.

That’s not what happened, though. As unemployment has fallen, hitting an almost seven-year low of 5.5 percent in February, wage gains are modest and inflation is nowhere to be found. That suggests the natural unemployment rate could be lower, something the Federal Open Market Committee acknowledged when it shifted its projections down this month.

Evans, Lockhart

Chicago Fed President Charles Evans said this month he thinks the natural unemployment rate might be around 5 percent, and the Atlanta Fed’s Dennis Lockhart said he’s “certainly sympathetic” with the idea that the rate has moved lower.

“The Fed is moving it down based simply on the notion that we aren’t seeing wage growth,” said Stephen Stanley, chief economist at Amherst Pierpont Securities LLC in Stamford, Connecticut, and a former Richmond Fed researcher. “It’s like groping in the dark.”

Monetary policy takes time to affect the economy, Stanley said. That means inflation could sneak up on policy makers if they wait to see “the whites of the eyes” before raising rates, Stanley said — and they might not be nimble enough to counteract it.

It’s a mistake to rely on estimates of the natural unemployment rate to set policy, said Athanasios Orphanides, a former senior adviser to the Fed’s Board of Governors and former governor of the Central Bank of Cyprus.

Accurately gauging the number in real time is impossible, he said in an interview. In the 1970s, the Fed based policy on a too-low estimate of the rate and helped send inflation spiraling above 10 percent.

Major Mistake

Today, some members of the FOMC are again taking their estimates of the equilibrium level “far more seriously” than they should, Orphanides said. “As a result, they are creating, perhaps without realizing it, the risk of a major policy mistake.”

While he said he doesn’t think policy makers would allow inflation to get as far out of hand as it did 40 years ago, he said the error could be “qualitatively” similar. To avoid that, central bankers should focus on price stability rather than so heavily on unemployment, he said.

There’s no sign that the Fed’s headed to an inflation overshoot. The core personal consumption expenditure price index, which excludes food and fuel, climbed 1.4 percent in February from the prior year. Including food and energy, the overall gauge rose 0.3 percent from a year earlier, remaining below the Fed’s 2 percent target for the 34th consecutive month.

Still Lower

Other economists, including Bank of America’s Hanson, say FOMC members could move their forecast for long-run unemployment lower still, in part because there may be more people available for work than today’s 5.5 percent unemployment rate suggests.

The headline jobless rate — which only counts people who clock no hours and who regularly apply for jobs — could underestimate labor-market slack, Hanson said. Some 6.6 million Americans are employed part time because they can’t get full-time work. Others aren’t actively applying for jobs so they’re counted as out of the workforce, yet they report that they’d like a job and often wind up moving into work.

Shadow Labor

Such “shadow” labor supply could hold down wage inflation, implying there is room for unemployment to fall further.

Fed policy makers might move their unemployment projections down to 5 percent over the course of the year, Hanson estimates. John Herrmann, a strategist at Mitsubishi UFJ Securities USA Inc. in New York, predicts that the FOMC will cut the projected rate to 4.8 percent in 2015. Herrmann’s model puts it at 4.7 percent, he wrote in a March 23 note to clients.

Even if the Fed’s current estimate of the natural level is correct, Johns Hopkins University economist Laurence Ball says it would make sense to push the actual jobless rate lower by keeping monetary policy accommodative.

“A likely side effect would be a temporary rise in inflation above the Fed’s target,” Ball wrote in a paper released Monday. “But that outcome is acceptable,” he wrote. “A high-pressure economy would create jobs for people who otherwise might be chronically unemployed, and push output back toward its pre-recession trend.”

Yellen last week said a gradual approach to tightening policy would help lift inflation to the Fed’s goal. That objective “would be advanced by allowing the unemployment rate to decline for a time somewhat below estimates of its longer-run sustainable level,” she said.

In the worst-case scenario, pushing unemployment below the natural rate might cause inflation to climb to 3 percent, requiring the Fed to tighten policy to bring price pressures under control, Ball said in an interview. If policy is tightened prematurely, however, “the worst-case scenario of sliding into deflation, and the economy getting weaker again, is very bad.”

To contact the reporter on this story: Jeanna Smialek in Washington at

To contact the editors responsible for this story: Chris Wellisz at Mark Rohner, Brendan Murray

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