That darn unemployment rate, its keeps getting lower. Why can’t it just stay where it’s supposed to stay, where our economic forecasting models say it should be?
Although this probably won’t be how the conversation ensues at the next meeting of the Federal Open Market Committee, it probably captures their sentiments concerning the perplexing situation where the unemployment rate keeps falling without causing an upward tick in inflation — confounding traditional economic theory that has been doctrinaire at the Federal Reserve for decades.
In the 1960s, economist Milton Friedman formulated what he theorized was the “natural rate of unemployment,” below which inflation would be sure to follow. The theory was based on the belief that this natural rate balances the supply and demand for labor, and when it drops below the specific rate, inflation accelerates— driven by employers paying higher wages to attract employees.
The Fed’s official estimates of the natural rate have varied, dropping in recent years as unemployment fell faster than they predicted. Their estimate three years ago tumbled from 5.1% to 4.7% last year to 4.5% in March. According to the theory, the current unemployment rate is already below safe levels.
The fear, not unfounded, is that the low unemployment rate in the 1960s led to a period of rampant inflation that wasn’t tamed until the late 1970s.
For the Fed, the unemployment rate has long been an important, if not the most important, economic indicator on which it relies in fulfilling its statutory role to manage the money supply to control inflation. But the problem is the past may no longer be prologue.
The unemployment rate is at its lowest level in 30 years. Back in the 1960s, when the rate was this low, the structure of the economy and composition of the labor force were quite different— two factors the natural unemployment rate theory does not address or consider.
It is gospel among most economists that the causal relationship between low unemployment and inflation is an iron law embodied in a theory called the Phillips curve, name after an Australian economist who enunciated the theory in 1958.
Among academic economists, who have traditionally led the Fed, the Philips curve is almost a sacrosanct principle. Jerome Powell’s predecessor, Janet Yellen, subscribed to the theory and responded with interest rate adjustments accordingly.
The current paradox presented to Powell is the current historically low unemployment has not caused an uptick in inflation as predicted by the Philips curve and the natural unemployment rate principle.
However, there is a contingent in the Fed that questions the utility of the theory.
"We are too focused on the unemployment rate number,” Minneapolis Fed President Neel Kashkari said in an April interview with the Wall Street Journal. He calls it a “broken gauge” that doesn’t capture extra labor market slack.
This group within the Fed argues that if inflation is the primary concern, then the Fed should wait until it sees it moving higher before raising interest rates, if at all. This approach would be anathema to the traditional inflation management theory so prevalent at the Fed.
The “traditional and well-founded preference for acting pre-emptively on a forecast is very much called into question” by the feeble response of inflation to declining unemployment, said Fed Vice Chairman Alan Blinder.
That is exactly the scenario that is currently unfolding, and which must be addressed by Powell, who is not an academic econometrician, but an attorney. He is not, unlike many previous Fed directors, a rigid doctrinaire when it comes to monetary policy. He has expressed a willingness to try different approaches that may deviate from the accepted Philips curve theory.
Whether he is successful in achieving the proper balance between a healthy economy, low unemployment rate and, most importantly, inflation that does not exceed the Fed's target of 2% remains to be seen.
