WITH pretty solid recovery now under way and the unemployment rate way down from its recession-era peak, the US Federal Reserve is wondering when to start raising interest rates. It had said it would be “patient” – which investors took to mean “not before the middle of this year”. That might not be patient enough.
The timing of the first increase depends – or ought to – on the outlook for inflation. The Fed’s calculation unavoidably involves guesswork, but here’s one way to look at it: The Fed can choose to err on the side of a bit too much inflation, or a bit too much unemployment. In current circumstances, the first error is preferable.
The Fed’s policy-making committee will aim to act early enough to keep inflation expectations in check, but not so early as to throttle the recovery. In striking this balance, the state of the labour market figures prominently. Once the recovery has taken up all the slack in the labour market, continued monetary stimulus will push wages higher, and inflationary pressure will grow. So the question is, how much slack remains?
With unemployment at 5.7 percent, the answer might seem to be “not much”. Most economists think that in the US, an unemployment rate of roughly 5 percent is full employment. But the recent recession was unusually severe, and the labour market was stretched out of shape.
The main problem is that the headline rate of unemployment excludes other measures of underemployment – in effect, hidden labour-market slack. These worsened during the recession. At the end of last year, almost 9 million people were unemployed. Excluded from that number were 2.3 million more who wanted a job but hadn’t “actively” looked for one in the previous month; also excluded were 6.8 million part-time workers who would have preferred to be working full time.
It’s impossible to say exactly how much extra patience from the Fed this disguised unemployment should justify, but keep another point in mind. Inflation is currently running at less than the Fed’s target of 2 percent, and the recent strength of the dollar will help to keep it there.
In short, there may be more slack in the labour market than the standard measure suggests, and there’s some latitude on inflation as well. Patience is a virtue. And there’s never been a better time for the Fed to be virtuous. – Bloomberg