Why 7% Unemployment Is Inflation Turning Point Fed Doesn't Say
Federal Reserve policy makers say full employment means a long-term jobless rate between 5 percent and 5.3 percent. Some of the most influential economists say they’re wrong.
Dean Maki at Barclays Capital, 2006 Nobel Prize-winner Edmund Phelps and Bank of America-Merrill Lynch’s Ethan Harris estimate the worst financial crisis since the Great Depression has pushed the so-called natural rate of unemployment to between 6.3 percent and 7.5 percent. Unless the Fed accepts that more Americans will be permanently out of work, the central bank may spur inflation by waiting too long to raise its benchmark rate from a record low, said Maki, Barclays’ chief U.S. economist and the most accurate forecaster in a December 2009 Bloomberg News survey.
Bondholders “must worry that if the natural unemployment rate is up to 7 percent, then there’s the danger that the Fed will keep piling on more stimulus money as if they didn’t have to worry” about joblessness, Phelps, 76, a professor at Columbia University in New York, said in an interview.
On a “cheerful day” Phelps said he estimates the rate, or NAIRU, has climbed to between 6.5 percent and 7 percent. On a “gloomy day,” he pegs it from 7 percent to 7.5 percent.
“If you knew for sure that the natural rate was 5 percent, then it might make sense for the unemployment rate to hit 7 or 7.5 percent before you start tightening at all,” Maki, 45, said in an interview from his New York office. “That becomes a very risky strategy when the natural rate has risen, because you could be sitting at a zero percent Fed funds rate at full employment and not realize it.”
Joblessness has stalled above 9 percent since May 2009 as about 8 million positions in the U.S. evaporated during the economic slump that began in December 2007, and companies from Detroit automaker General Motors Co. to Hollywood, Florida, homebuilder Tousa Inc. declared bankruptcy.
Maki said the natural rate -- the level that neither accelerates nor decelerates inflation -- will remain high because there’s a mismatch between available jobs and the skills of the unemployed. People whose homes are worth less than their mortgages also may be reluctant to move for work, and the extension of unemployment benefits deters some people from accepting employment with lower pay because a portion of their lost income has been replaced, Maki said.
While inflation isn’t a threat now, investors should sell 10-year and 30-year Treasuries, buy Treasury Inflation-Protected Securities and limit their exposure to the U.S. dollar if it does become apparent, said Arthur Tetyevsky, chief U.S. fixed- income strategist at investment bank Gleacher & Co. in New York and former chief U.S. credit strategist at HSBC Securities USA.
‘Overstimulating’ the Economy
“If we try to reach a target that’s consistent with what historical NAIRU levels were, we run the risk of keeping rates too low and overstimulating the economy,” he said.
The Labor Department on June 4 will report the jobless rate fell to 9.8 percent in May from 9.9 percent in April and private payrolls increased by 175,000, according to the median forecasts of economists in Bloomberg News surveys. While nongovernment employers added 231,000 jobs in April, the most in four years, the unemployment rate rose from 9.7 percent in March as more people entered the labor force looking for work. Economists in Bloomberg News surveys forecast the rate will fall to 9.6 percent for the year and 9 percent in 2011, according to the median estimates.
The jobs market is “beginning to improve,” Fed policy makers said after the Federal Open Market Committee meeting April 27-28, adding they need to see more signs of sustained gains before ending their pledge to keep the rate on overnight loans among banks between zero and 0.25 percent for an “extended period.”
Even so, their estimates for the longer-run unemployment rate -- a proxy for the natural rate -- have been creeping up. Two participants at the April meeting put it between 6 percent and 6.3 percent; everyone else said it is 5 percent to 5.3 percent, according to the minutes. A year earlier, none of the policy makers projected a rate higher than 5.3 percent, and five forecast it was below 5 percent.
Central bankers may be loathe to keep raising their estimates because it’s politically unpopular to say more Americans should be out of work to create equilibrium in the economy, Maki said.
The danger of the Fed targeting unemployment below the natural rate was illustrated in the 1970s. The central bank kept borrowing costs low in pursuit of full employment, leading to double-digit increases in prices, according to Maki. That later forced policy makers to raise their benchmark rate to 20 percent in the early 1980s.
“At the time, the Fed thought the rate was 4 percent, and it was really about 7 percent,” Maki said. “That was one of the key mistakes that helped lead to the ‘great inflation’ of the 1970s.”
Michelle Smith, a spokeswoman for the Fed in Washington, declined to comment.
A higher natural jobless rate would be a drag on the U.S. budget deficit, which reached a record $1.4 trillion last year, because the government would collect less tax revenue while spending more on benefits. The Congressional Budget Office in January estimated the rate is about 5 percent.
The number has changed only slightly since 2000 and is “suspiciously round,” Harris, 53, said in a May 14 report. The Fed’s forecasts are also “surprisingly stable,” he added. He estimates the rate is about 6.3 percent.
While the Fed’s prediction may be too low, the central bank has ample time to revise its assessment before worrying about overheating the economy because increasing price pressure isn’t a threat now, Harris, head of North America economics at Bank of America-Merrill Lynch Global Research, said in a May 24 interview.
The Fed’s preferred gauge of inflation, the personal consumption expenditures index excluding food and energy, slowed to a 1.2 percent annual rate in April from 1.7 percent a year earlier, according to a May 28 Commerce Department report. That’s below the central bank’s longer-run goal of 1.7 percent to 2 percent inflation.
Many economists say that, if anything, the natural rate of unemployment could be much lower than 7 percent. John Lonski, chief economist at Moody’s Capital Markets Group in New York, said he expects to see increased demand for U.S. workers within five years as baby boomers start to retire, shrinking the labor force.
“Believe it or not, you’re going to go from having a surplus of labor to having shortages of labor five to 10 years from now,” Lonski said in an interview.
Harris said his forecast for a higher natural rate is based on a “misallocation of resources in the economy,” partly because many people flocked to housing-related work that disappeared when the real-estate bubble burst. He also cited a spike in long-term joblessness, as the number of people out of work 27 weeks or more rose in April to a record 45.9 percent of all the unemployed, according to the Labor Department.
Deutsche Bank AG economists estimate the natural rate has risen as high as 6 percent while the U.S. economy’s potential growth has slowed, which means “the current slack will diminish more quickly than previously thought,” they wrote in a May 19 report.
For the central bank to increase its benchmark rate to a “neutral” level of at least 4 percent a year ahead of the economy’s return to potential, possibly as soon as mid-2013, the Fed would need to alternate increases of 25 basis points and 50 basis points at each meeting between January 2011 and June 2012, “unless it starts sooner,” the Deutsche Bank economists said.
“The Fed may have less margin for error than is commonly assumed in the direction of delaying its exit too long and letting inflation pressures begin to build,” they said.