Federal Reserve Chairwoman Janet Yellen proclaimed “welcome news” in April: The prospect of a healthy economy was within the medium-term forecast. Fed officials expected the unemployment rate to fall to near 5.5 percent, with inflation stabilizing near the Fed's 2 percent target.
The forecast was “plausible,” said Yellen, and if accurate would mean that “the economy would be approaching what my colleagues and I view as maximum employment and price stability for the first time in nearly a decade.”
Those projections, made in March, were for 2016. But they’re closer to the projections for 2015 released by the Fed’s monetary policy committee Wednesday. The “maximum employment” scenario Yellen hoped for appears to be slated for a year earlier than expected.
Fed officials’ June economic projections put unemployment at between 5.4 to 5.7 percent by the end of 2014, with inflation between 1.5 percent and the Fed’s 2 percent target. The improvement in the outlook, coming after a contraction in the first quarter of 2014, is a reflection of the unemployment rate falling faster than expected and other signs of accelerating commerce. In the latest readings, unemployment has dropped to 6.3 percent, and some measures of inflation have eclipsed 2 percent.
The anticipated decline in the jobless rate raises the possibility that the Fed will face a tradeoff between reducing unemployment and risking above-target inflation sooner than expected.
The Fed subscribes to the idea, first hypothesized by Nobel Prize winning economists Milton Friedman and Edmund Phelps during the late 1960s, that there is a certain level of unemployment consistent with stable prices. This long-term or natural rate of unemployment reflects the normal processes of people switching jobs, students entering the workforce, workers retiring, businesses failing and so on — what is called “frictional” and “structural” unemployment, as opposed to cyclical.
When unemployment is at this natural rate, attempts by the Fed to expand the money supply will not boost commerce and create jobs, but instead ultimately lead to a higher prices as more money chases the same amount of goods and services.
Economists offer different guesses on what the natural rate might be based on the relationship among measured unemployment, job vacancies, inflation and other factors.
Fed officials placed the unemployment rate between 5.2 to 5.5 percent in projections issued Wednesday. Yellen has not offered a specific projection of her own, but in testimony last July predecessor Ben Bernanke suggested it was around 5.6 percent. The Congressional Budget Office publishes a related estimate, showing the rate currently at 5.8 percent and dropping to 5.7 percent in the second half of 2015.
The Fed sees unemployment dropping below that rate sometime in early to mid-2015, meaning that the economy could reach Yellen’s version of full employment and spark above-target inflation a year ahead of what she expected just a few months ago.
A similar development took place before the financial crisis, when the CBO’s estimate of the natural unemployment rate was 5 percent. At the peak of the housing bubble years, from the end of 2005 to the end of 2007, the unemployment rate was below 5 percent, falling as low as 4.4 percent. And inflation ran above 2 percent for most of that period as well.
But the situation this time is complicated by years of labor market trauma. The financial crisis raised natural unemployment, according to the CBO, because structural unemployment is higher for a variety of reasons. That includes mismatches between job offerings and the skills and locations of workers, and the extension of unemployment benefits that can make workers less willing to take open positions. Most importantly, it reflects rising long-term unemployment, which can lead to workers becoming disconnected from the job market.
Yellen has made it clear that she thinks that there will be still be labor market “slack” -- that is, cyclical unemployment that can be addressed by monetary stimulus -- even when the unemployment rate normalizes. In a March speech in Chicago, Yellen cited the elevated long-term unemployment rate, the high number of people forced into part-time work, slow wage growth and the depressed labor force participation rate as further indications of slack.
The big question, then, is whether inflation will start to rise even when those additional indicators show slack remaining.
Yellen and the Fed have suggested they’re willing to hold off rate hikes and allow a temporary rise in inflation to find out. Wednesday’s monetary policy announcement stated that “even after employment and inflation are near” their targets, “economic conditions may, for some time, warrant keeping [short-term interest rates] below levels the Committee views as normal in the longer run.”