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Federal Reserve weighs interest rate hike as employment rises

By Steve Matthews

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(Bloomberg) — As the U.S. jobless rate reaches the range that the Federal Reserve defines as full employment, some Fed officials are asking a question: How low can you go?

Their answer: less than the 5.2 percent to 5.5 percent the Fed currently defines as the lowest that can be achieved without heating up inflation. Some Chicago Fed economists say this sweet spot, often called full employment or the natural rate of unemployment, may be as low as 5 percent.

Their boss, Chicago Fed President Charles Evans, is among policy makers who have lowered their estimates for the normal rate. “I now think that it might be something more like 5.0 percent,” Evans said in a speech Wednesday.

He’s not alone. “A few” members of the policy-making Federal Open Market Committee lowered their estimates in light of “continued softness” in inflation, according to minutes of the Jan. 27-28 meeting, which didn’t identify the officials.

The question is more than academic: It may influence how much longer officials keep interest rates near zero, where they have been since December 2008. Policy makers will next estimate their view of long-run unemployment at the March 17-18 meeting in Washington, and are likely to lower the goal, said JPMorgan Chase & Co. economist Jesse Edgerton in New York.

If officials shift their views, “you would argue to hold rates lower for longer,” said Edgerton, a former Fed economist.

Investors now see the Fed keeping rates low even longer than policy makers themselves do. Futures based on the federal funds rate imply a rate of 0.51 percent in December 2015. Fed officials expect the benchmark funds rate to trade in a range between 1 percent and 1.25 percent by the end of 2015, according to the median estimate of their quarterly forecasts in December.

One reason the long-term unemployment rate may be lower than officials currently estimate: Demographic changes mean the out-of-work population includes fewer hard-to-employ groups such as teenagers and is more dominated by older, better-educated people.

That implies more room for the unemployment rate to fall because those people are more likely to have skills that are in demand. Such changes in the labor force mean the jobless rate representing full employment has dropped as much as 0.6 percentage point since 2000, according to the research by the Chicago economists.

“This is a matter of debate and continuing discussion,” Atlanta Fed President Dennis Lockhart said Feb. 6, adding he is “certainly sympathetic” with the idea of a lower rate.

Added urgency

The Fed’s definition of full employment is taking on added urgency as joblessness has fallen more quickly than policy makers expected. The Labor Department reported Friday that unemployment fell to 5.5 percent in February, the lowest level since May 2008. The jobless rate will be 5.4 percent at the end of the second quarter and 5.3 percent at the end of the third, according to the median estimates of 65 economists surveyed by Bloomberg News Feb. 6 to Feb. 11.

Getting the unemployment target wrong could be a costly mistake. The Fed’s mandates from Congress include price stability, which it defines as 2 percent inflation, and maximum sustained employment.

Declaring full-employment victory while the jobless rate remains too high could leave the central bank with monetary policy that’s too tight and limits job growth. Aiming for a too-low jobless rate might cause the Fed to be late dealing with inflation or asset-price bubbles.

Self-fulfilling

“The Fed’s idea” of long-term unemployment “is somewhat self-fulfilling, and is another reason to err on the side of expansionary policy,” says Laurence Ball, an economist at Johns Hopkins University in Baltimore who’s researched the natural rate. “If the Fed guides unemployment to 5.3 percent and keeps it there, that may become established as the sustainable level of unemployment.”

The absence of any inflationary pressure suggests there is still considerable slack in the job market, said Gary Burtless, a Brookings Institution economist in Washington who previously was with the U.S. Labor Department.

The Fed’s preferred measure of inflation, based on consumer spending, rose 0.2 percent in January from a year earlier, the smallest 12-month gain since October 2009. The gauge hasn’t been above the central bank’s 2 percent goal since March 2012.

“Where’s the acceleration that is supposed to accompany our declining unemployment rate?” Burtless said.

One official who’s skeptical of that view is James Bullard, president of the St. Louis Fed. He’s worried the Fed will err on the side of keeping rates low for too long, and he predicts unemployment will fall below 5 percent in the second half of the year.

“The last two times that we’ve had unemployment go below the natural rate” were “associated with a bubble,” Bullard said in a Bloomberg News interview in New York in January. In 2007, pushing the federal funds rate down “ended in global macroeconomic disaster.”

Bullard favors moving more quickly than most of his colleagues to raise interest rates, saying “the die is already cast” that unemployment will go below the rate that is consistent with stable inflation.

Mixed signals

William Dickens, a visiting scholar at the Boston Fed, isn’t so sure, saying “there are mixed signals as to whether we are at full employment.”

While his research indicates “we are at the natural rate now,” the lack of certainty suggests holding off on rate increases, said Dickens, a Northeastern University professor and Brookings Institution senior fellow.

“Don’t fire until you start seeing real signs of price inflation, there is sufficient uncertainty” about where full employment is, he said.

Robert Hall, an economics professor at Stanford University in California and chairman of the National Bureau of Economic Research committee that determines when recessions begin and end, said the “ambiguous results” from research on the natural rate of unemployment call for Fed restraint.

“We will be feeling our way toward the lower limit on unemployment,” he said. “The Fed should not tighten based on falling unemployment, but rather on rising inflation forecasts, something that hasn’t clearly happened yet.”

–With assistance from Catarina Saraiva in Washington and Matthew Boesler in New York.

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