US Monetary Policy / On unemployment vs the fear of inflation

…The Fed’s reliance on the unemployment rate for determining when to pull back on bond purchases may prove troublesome. That’s because statistics on the supply of labor are notoriously tricky to evaluate, particularly when it comes to gaging their relationship to inflation.

The 6.5% target is well above the 5.5% figure that conventional wisdom says is “full employment,” the level below which the supply of workers is so tight that wages rise and create an inflationary spiral. The reason for the 6.5% target was to start tightening the money supply before inflation kicks in. But at its December meeting, the Fed’s Open Market Committee said it would maintain the current low targets for the federal funds rate-0% to 0.25%- “well past the time that the unemployment rate declines below 6.5%.“

That could lead the Fed on to treacherous terrain. The Fed evidently believes there’s still plenty of slack in the labor market because the number of unemployed and part-time workers is large. The labor participation rate has plunged from 66% before the recession to 1970s levels of 63%. People are not considered part of the work force if they have stopped looking for work. The prospect that these folks on the sidelines can jump in when the economy rebounds, the thinking goes, keeps wages low and inflation at bay.

But a number of factors have changed the calculus in recent times. For starters, a significant portion of the decline in labor participation is due to the retirement of baby boomers, who will not come back to the work force. Gerald Cohen, a senior fellow at the Brookings Institution and former Fed staffer, estimates that a third of the decline in the official participation rate is due to the aging population.

Low Wages Unrealistic

In addition, some of the unemployed and workers no longer looking for jobs don’t have the skills employers need. And even if they have the right skills, the long-term unemployed, like the 1.3 million who lost their unemployment benefits at the end of the year, are not attractive to employers. The long-term unemployed don’t put much downward pressure on wages because “given the choice, employers will hire someone who’s been working recently,” says Katherine Abraham, a University of Maryland professor and former Bureau of Labor Statistics commissioner.

Employers’ belief that the labor oversupply can keep wages down may prompt them to offer unrealistically low wages for job openings, which would help explain why advertised jobs rose 63% in October compared with October 2009 while hiring rose only 18%. Add all this together and it suggests that wages for qualified, active workers will have to rise if employers want to fill those openings. That, in turn, may mean the full-employment rate is higher than the 5.5% the Fed assumes. “It may be that it’s a bit higher than it was before we went into the recession,” Abraham says.

Former Fed Chairman Ben Bernanke said at his December 18 news conference that once unemployment gets to 6.5%, the Fed will look at a variety of factors, including hiring, quits, vacancies, participation, long-term unemployment, and wages. That looks a lot like fine-tuning, which has never been able to prevent booms and busts (think housing).

It’s relatively easy to assess the demand side of the macroeconomic equation: Just look at spending data and household balance sheets. Analyzing the supply side of the equation—plant capacity, the labor pool, and productivity—is harder. “The greater risk for policy mistakes is misunderstanding the supply side of the economy,” says Cohen.

The Bottom Line

So on paper, it may look as if the Fed has a lot of running room because of what seems like a lot of slack in labor markets. But if inflation erupts and interest rates rise, hammering both bonds and stocks, people may focus on the wrong cause, the need to unwind the Fed’s $4 trillion bond position.

Chosen excerpts by Job Market Monitor. Read the whole story at  

via Fed’s Yellen Risks Inflation Spiral With Unemployment Target.

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