YELLEN´S FED MIGHT BE FEELING DEJA VU / THE WALL STREET JOURNAL

Yellen’s Fed Might Be Feeling Deja Vu

 

By Ben Leubsdorf




Unemployment was headed lower. While consumer-price gauges remained steady, a Federal Reserve official warned that the U.S. economy was “operating in an inflationary danger zone” that justified raising interest rates.

That was September 1996. The Fed today faces a similar conundrum and the official who was pressing for a rate increase 19 years ago—then board governor Janet Yellen--is now the central bank’s powerful chairwoman.

In theory, when unemployment falls low enough and the labor market tightens, wage and price growth accelerates. Ms. Yellen has long cited the so-called Phillips curve describing that relationship as a framework for understanding the economy and the Fed’s looming decision on when to raise short-term interest rates that have been pinned near zero for nearly seven years. “An important factor working to increase my confidence in the inflation outlook will be continued improvement in the labor market,” she said in March. “A substantial body of theory, informed by considerable historical evidence, suggests that inflation will eventually begin to rise as resource utilization continues to tighten.”

But the Phillips curve’s shortcomings – the relationship between slack and inflation shifts over time and has become increasingly elusive in U.S. data -- limit its practical use as a tool to predict the future or fine-tune monetary policy. If the U.S. labor market is approaching full health, why are price inflation and wage growth still so low? That uncertainty is weighing on policy makers ahead of the Fed’s Sept. 16-17 meeting. At their July meeting, several Fed officials “noted that higher rates of resource utilization appeared to have had only very limited effects to date on wages and prices, and underscored the uncertainty surrounding the inflation process as well as the role and dynamics of inflation expectations,” according to minutes released last week.

The Fed’s experience in the mid-1990s offers interesting parallels. Then, as now, falling unemployment with little response from inflation left the Fed less certain about the economy’s capacity. Then, as now, the central bank revised down estimates for the level of unemployment at which inflation pressures emerge in earnest.

A key difference is that two decades ago, Chairman Alan Greenspan’s Fed came to realize a surge in labor productivity was temporarily allowing joblessness to fall without stoking higher inflation. Today, productivity growth has flatlined.

Some forces may be temporarily holding down inflation now, such as the strong dollar and low oil prices. But if the economy remains on track and slack in the labor market continues to shrink, price growth should eventually accelerate. Because monetary policy operates with long lags, the Fed will have to raise interest rates to keep inflation in check.

At least, that seems to be the Fed’s theory. We’ll find out in a few weeks if it’s convinced enough to act on it.