April 20, 2014 6:46 pm
Wage inflation threatens Fed interest rate plans, say economists
High long-term unemployment in the US may fail to hold down inflation, creating a challenge for Federal Reserve plans to keep interest rates low well into 2015, according to economic analysis.
A growing body of research from high-profile economists, including Alan Krueger, who chaired President Barack Obama’s council of economic advisers until August, suggests that wage inflation could soon rise because short-term unemployment is almost back at normal levels.
If such wage pressures start to show up this year, they could force the Fed to consider earlier interest rates rises even while the unemployment rate remains relatively high.
However, Fed chairwoman Janet Yellen has rejected the idea that long-term unemployment will fail to hold down inflation. “I think it’s premature, frankly, to jump to that conclusion,” she said in response to a question after a speech in New York last week.
At this stage, however, almost all of the extra unemployment is long-term, due to people being out of work for half a year or more. The short-term unemployment rate, at 4.3 per cent, is more or less back to its long-run average.
The standard economic story says there is a negative relationship between unemployment and inflation. When unemployment falls close to its long-run level, there is more competition for workers, which starts to drive wages up.
But research – by economists including Robert Gordon of Northwestern University and Mark Watson of Princeton – suggests that not all unemployment is equal. In particular, they find inflation forecasts become more accurate when they exclude the long-term unemployed from their calculations.
In a paper, Mr Krueger and his colleagues argued that the long-term unemployed are on the margins of the labour force, both because they give up on intensively searching for a job and because employers start to discriminate against them. “We tentatively conclude that the long-term unemployed exert relatively little pressure on the economy.”
There are several possible problems with the researchers’ arguments about long-term unemployment. The results are sensitive to the methods used by analysts. Until now, there has been almost no time in US history with a sustained period of long-term unemployment, so all the results draw on the thinnest of data. Mr Krueger’s paper looks to the UK and Sweden for more evidence.
Even if it turns out that long-term unemployment does not hold down inflation, other factors could, such as the large number of people who have dropped out of the US labour force.
Copyright The Financial Times Limited 2014.
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