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--Hiking Too Slowly Risks Overheating Labor Market
--Expect Inflation to Rise as Labor Market Strengthens
--Significant Uncertainties Facing Inflation Outlook
By Jean Yung
     WASHINGTON (MNI) - A midyear shortfall in inflation is "probably temporary"
though considerable uncertainty over the outlook for inflation strengthens the
case for the Federal Reserve to tighten monetary policy in a not-too-fast and
not-too-slow manner, Chair Janet Yellen said Tuesday as she laid out an in-depth
analysis of the central bank's inflation model. 
     "How should policy be formulated in the face of such significant
uncertainties? In my view, it strengthens the case for a gradual pace of
adjustments," Yellen said in remarks prepared for a conference in Cleveland. 
     "A gradual approach is particularly appropriate in light of subdued
inflation and a low neutral real interest rate, which imply that the FOMC will
have only limited scope to cut the federal funds rate should the economy be hit
with an adverse shock," she said. 
     "But we should also be wary of moving too gradually" as there is a risk
that the labor market could eventually become overheated, potentially creating
an inflationary problem down the road that might be difficult to overcome
without triggering a recession." 
     Yellen said she and her colleagues on the Federal Open Market Committee
"currently think that this year's low inflation is probably temporary," and
continue to anticipate the inflation will stabilize around 2% over the next few
years. 
     However, this conclusion is based on some key assumptions that "could be
wrong in ways that imply that inflation will remain low for longer than
currently projected." These include: labor market conditions may not be as tight
as they appear; long-run inflation expectations may not be as well anchored at
2% as policymakers believe; and finally that the Fed's framework for
understanding inflation could be "misspecified in some fundamental way," Yellen
said. 
     Yellen reiterated that she believe the factors that have held down
inflation "should fade over time." Some of the recent decline in inflation
"reflects idiosyncratic shifts in the prices of some items," including a one-off
drop in wireless service prices. 
     Some analysts have pointed to sluggish wage growth as evidence that the
labor market has not returned to full strength, Yellen said, but some analysis
suggests that "subdued growth for the country as a whole probably reflects
sluggish productivity or some other factor common to all states." 
     She also noted that surveys indicate more firms are planning wage increases
and have difficulties finding qualified workers -- "possible harbingers of
stronger wage gains to come."
     She warned that it is possible inflation "may rise more sharply in response
to robust labor market conditions than anticipated." Just as economists are not
sure why the Phillips Curve has become so flat over the past two decades, they
cannot be sure that it will stay flat in the face of strong labor market
conditions. 
     "Overall, I view the data we have in hand as suggesting a generally healthy
labor market, not one in which substantial slack remains or one that is
overheated," the Fed chair said. 
     Turning to inflation expectations, Yellen conceded that there is some
evidence that expectations "may have slipped a bit over the past two or three
years" and if that were the case, then "stabilizing inflation at around 2
percent could prove to be more difficult than expected." 
     However, the FOMC currently believes inflation expectations overall will be
reasonably well anchored at 2%. 
     Yellen finally discussed the possibility that supply side shocks or global
factors could have lasting impact on U.S. inflation but drew no strong
conclusions. 
     She repeated the FOMC is committed to its inflation goal and will keep an
open mind on the best monetary policy necessary to fulfill its mandate.   
--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com
[TOPICS: MMUFE$,M$U$$$]