A Whiff of Inflation Around the Corner?

April 20th, 2014 9:19 pm | by John Jansen |

The FT has an interesting post on long term unemployment and wages. The article cites academic studies which posit that the long term unemployed are out of the work force and therefore will exert little downward pressure on wages. The folks who hold this view think that wage inflation is possible as short term unemployment is back near historical averages.

Via the FT:

Wage inflation threatens Fed interest rate plans, say economists

By Robin Harding in Washington

High long-term unemployment in the US may fail to hold down inflation, creating a challenge for Federal Reserve plans to keep interest rates low well into 2015, according to economic analysis.

A growing body of research from high-profile economists, including Alan Krueger, who chaired President Barack Obama’s council of economic advisers until August, suggests that wage inflation could soon rise because short-term unemployment is almost back at normal levels.

If such wage pressures start to show up this year, they could force the Fed to consider earlier interest rates rises even while the unemployment rate remains relatively high.

However, Fed chairwoman Janet Yellen has rejected the idea that long-term unemployment will fail to hold down inflation. “I think it’s premature, frankly, to jump to that conclusion,” she said in response to a question after a speech in New York last week.

Most estimates put the natural rate of unemployment – the lowest rate an economy can sustain before inflation rises – at 5.5-6 per cent in the US. The current rate is 6.7 per cent, so it still has a full percentage point to fall, suggesting that there is plenty of spare capacity in the economy.

At this stage, however, almost all of the extra unemployment is long-term, due to people being out of work for half a year or more. The short-term unemployment rate, at 4.3 per cent, is more or less back to its long-run average.

The standard economic story says there is a negative relationship between unemployment and inflation. When unemployment falls close to its long-run level, there is more competition for workers, which starts to drive wages up.

But research – by economists including Robert Gordon of Northwestern University and Mark Watson of Princeton – suggests that not all unemployment is equal. In particular, they find inflation forecasts become more accurate when they exclude the long-term unemployed from their calculations.

In a paper, Mr Krueger and his colleagues argued that the long-term unemployed are on the margins of the labour force, both because they give up on intensively searching for a job and because employers start to discriminate against them. “We tentatively conclude that the long-term unemployed exert relatively little pressure on the economy.”

As a result, long-term unemployment does little to hold down wages, and with short-term unemployment back to normal they could start to rise. Most measures of US wage inflation are still sluggish but Ms Yellen said the Fed would be alert to “wage pressures that can translate into price pressures and be an early warning indicator of an impending uptick in inflation”.

There are several possible problems with the researchers’ arguments about long-term unemployment. The results are sensitive to the methods used by analysts. Until now, there has been almost no time in US history with a sustained period of long-term unemployment, so all the results draw on the thinnest of data. Mr Krueger’s paper looks to the UK and Sweden for more evidence.

Meanwhile, researchers at Deutsche Bank looked at recent patterns in US states and found long-term unemployment does have an effect in holding down inflation but only kicks in once short-term unemployment is back to normal. That would suggest Ms Yellen’s patience is wise.

Even if it turns out that long-term unemployment does not hold down inflation, other factors could, such as the large number of people who have dropped out of the US labour force.

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