Fed Fear Of The Jobless Rate

It may be a faulty inflation signal

Though they welcome the Federal Reserve's latest cut in short-term interest rates, economists Mickey D. Levy of NationsBanc Capital Markets Inc. and Joseph Carson of Dean Witter Reynolds Inc. both believe that Fed policy remains far too restrictive in the face of growing economic weakness. As they see it, the largest roadblock to a substantial easing of monetary policy may well be the Fed's unjustified concern regarding the low unemployment rate.

Fed officials, says Levy, tend to believe in a so-called natural rate of unemployment--that is, a rate at which labor markets are so tight that further declines would spark rising inflation. Though estimates of that rate have varied from 4% in the 1960s to 6.5% in the 1970s, the current level is presumed to be just below 6%--placing November's 5.6% jobless rate in the danger zone.

Levy argues, however, that productivity progress by U.S. business combined with the Fed's enhanced inflation-fighting credibility have effectively lowered the natural rate of unemployment well below the 5.5%-to-6% range. By reaping productivity gains from restructuring and more flexible use of labor (including contingent workers), as well as from increased investment in technology, says Levy, business has improved its resiliency in labor markets and boosted its leverage in wage bargaining.

Meanwhile, growing job insecurity has made employees more docile. And the Fed's tough anti-inflation stance has curbed employers' ability to pay for wage hikes by raising prices. All of which, says Levy, suggests that today's 5.6% jobless rate is far from a danger signal of impending inflation.

For his part, Carson notes that the meager 607,000 rise in employment over the past 12 months (as measured by the Labor Dept.'s survey of households) was matched by unusually sluggish labor force growth of just 724,000 people. This is only half of the 1.1% growth in the labor force in 1994 (chart), which was right in line with Labor Dept. projections.

Carson attributes this sharp drop in labor force growth to declines in labor force participation by 20-to-24-year-old and 55-to-64-year-old males. He speculates that poor job prospects in 1995 inspired more young workers to stay in school, while continued downsizing eroded the ranks of older workers. In any case, he says, "the thing to remember is that the unemployment rate would be a half a percentage point higher if the labor force had expanded at its trend rate."

Either Levy's or Carson's analysis may explain why inflation has stayed so low with 5.6% unemployment. If, as seems likely, they are both right, the Fed has more than ample room to ease aggressively in the months ahead.

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