Fed Staff Paper Warns Officials Not to Ignore Low Unemployment

Fed Staff Paper Warns Officials Not to Ignore Low Unemployment

Ignoring the low unemployment rate and paying more attention to what happens with inflation may not be a wise strategy for Federal Reserve officials, according to a new paper by researchers at the U.S. central bank.

“Policy needs to take proper account of the prospects for persistently tight labor markets leading to higher inflation, or other imbalances, that could eventually endanger prospects on the employment side of their policy mandate,” a group of top Fed economists led by Christopher Erceg wrote in the paper, which was published Thursday on the Fed’s website.

Federal Reserve Chairman Jerome Powell is scheduled to speak Friday on the topic of “Monetary Policy in a Changing Economy” during an annual gathering of central bankers in Jackson Hole, Wyoming. The Fed staff paper addresses the question at the heart of the matter: what should policy makers do with interest rates if they are uncertain about the true level of the so-called natural rate of unemployment, which may change over time as the economy changes?

The natural rate concept — the theoretical amount of unemployment which would keep inflation stable — is central to the Fed’s strategy of keeping price pressures in check. According to projections published in June, the median estimate of Fed officials for the natural rate is 4.5 percent. Actual U.S. unemployment fell to 3.9 percent in July.

Arguably, Fed officials have in recent years given more consideration to unexpectedly low inflation than low unemployment when setting interest rates, given their estimates of the natural rate of unemployment. Only recently has inflation risen back to levels near the U.S. central bank’s 2 percent target.

The Fed economists cited a 2007 paper co-authored by now-New York Fed President John Williams as an example of an “influential” body of research which “recommends that monetary policy reduce the responsiveness of the policy rate to measures of slack, and instead focus more on movements in inflation.”

“Uncertainties about natural rate of unemployment have led many researchers to conclude that policy makers would be well advised to ignore potentially mismeasured labor market slack,” they wrote. “Because monetary policy acts with a lag, waiting for inflation to materialize before reacting is undesirable.”

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Author: HEDGE

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