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Fed Looks for Goldilocks Path as Jobless Rate Drops

29 Jul 2018 1:00 pm
By Nick Timiraos 

Most Federal Reserve officials agree on the path for interest rates over roughly the next year: proceed with gradual increases until borrowing costs reach a level that neither slows nor spurs growth.

The big question, however, is what to do after getting to that so-called neutral setting. The answer will largely depend on how inflation behaves as unemployment falls, and they are poring over recent research for clues.

The studies suggest prices might climb faster, but not too much, if unemployment falls a bit more. And inflation might become worrisome if joblessness falls a lot more.

The policy makers are likely to leave their benchmark rate unchanged when their two-day policy meeting concludes Wednesday and wait until September for their next increase. They raised the rate twice this year, most recently in June to a range between 1.75% and 2%, and have penciled in two more moves this year.

"The economy seems so strong it seems natural that businesses and consumers can live with more neutral financial interest rates," said Chicago Fed President Charles Evans in a recent interview. "Then it becomes more important to take stock of...how much inflationary pressures do we see building up, if any."

Fed officials want to raise rates enough to prevent the rapidly expanding economy from overheating, but not so much that they choke off healthy growth prematurely.

So far, they are succeeding. The central bank is closer to meeting its two congressional mandates to maximize employment and maintain stable prices than at any time in the past decade.

Unemployment rose to 4% in June from 3.8% in May for mostly good reasons -- a large jump in the number of Americans looking for jobs who previously hadn't been. Excluding volatile food and energy categories, inflation rose 2% in May from one year earlier. It was the first time in six years that so-called core inflation, using the Fed's preferred gauge, reached the central bank's target.

Now, Fed Chairman Jerome Powell is watching for signs the economy could go in either of two directions.

In one scenario, inflation accelerates once unemployment falls to very low levels, requiring more-aggressive rate increases to keep price pressures in check.

In the other, a period of sustained low unemployment draws more workers into the labor force while inflation pressures stay under control.

Fed researchers recently examined both possibilities.

One study analyzed data for U.S. metropolitan areas to see what happens to inflation when unemployment is very low.

Economists have long held that inflation rises as unemployment falls, and vice versa. But the relationship, called the Phillips curve, has appeared very weak in recent decades. Inflation has remained tame even as the jobless rate declined to 4% in June from 10% in 2009.

The Fed economists found, however, that inflation picked up more quickly once the unemployment rate fell below 3.75%.

One of the researchers, Alan Detmeister, who now works at UBS Group AG, said that when the Fed began the study in 2016, he considered it "highly unlikely" the U.S. unemployment rate would reach 3.75% and played down the results. "Now we're kind of at that point," he said.

In the late 1960s, the last time unemployment fell below 4% for a sustained period, inflation steadily accelerated. By the 1970s, if inflation rose one year, consumers expected it to rise at least as much the following year -- and it did. Fed officials believe expectations of future inflation can be self-fulfilling as workers demand pay increases and businesses raise prices in anticipation.

Separate Fed research published in 2016 used data from the 1960s to measure the level at which inflation pressures begin to harm the economy. The researchers concluded this happens when core consumer prices rise by 3% on a sustained basis, according to the Fed's preferred gauge.

Economists say that inflation accelerates when unemployment falls below a so-called natural level, which Fed officials estimate at 4.1% to 4.7%.

The "point at which you can get a large inflation overshoot" approaching 3% is when the jobless rate falls 1.5 percentage points below the natural level, said Jeremy Nalewaik, the study's author, who now works at Morgan Stanley.

Fed officials are also eager to know how much workers might benefit when unemployment is very low. The policy makers wonder whether people at the margins of the labor market might more easily find jobs, gain skills and become more productive -- permanently improving their chances of employment. This would lower the natural unemployment rate and reduce the prospect of the economy overheating.

Researchers at the Cleveland Fed, using state-level data, looked for signs that periods of low joblessness delivered lasting benefits to less-educated, working-age men.

Their conclusion: "Once the labor market returns to a sort of normal state, the benefits from a tight labor market to these disadvantaged groups don't last very long," said Bruce Fallick, a co-author of the study.

Mr. Powell has signaled he is looking carefully at current economic data to discern which of the two scenarios looks more likely.

One difficulty he notes is that two of the crucial variables can only be estimated, rather than observed -- the neutral rate of interest and the natural level of unemployment.

"It's difficult to forecast the economy and these concepts that we have, " Mr. Powell said in a radio interview in July. "It's not like the fact that water boils at 212 degrees. The economy doesn't boil at 4% unemployment."

Write to Nick Timiraos at nick.timiraos@wsj.com

(END) Dow Jones Newswires

July 29, 2018 09:00 ET (13:00 GMT)

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