MNI Fed State Of Play: Note of Caution as 2018 Gets Underway

     WASHINGTON (MNI) - The Federal Reserve is set to carefully evaluate a shift

in the balance of risks to its dual mandate amid soaring job growth and sagging

inflation, and with Jay Powell preparing to take the helm from outgoing Chair

Janet Yellen next month.

     In light of the continued shortfall in inflation, which has mystified

officials, economists are calling into question the Phillips curve -- a key part

of the Fed's conventional thinking. The unemployment rate is half a percentage

point below the Federal Open Market Committee's estimate of maximum employment,

but so far that has not translated into any significant upward pressure on wages

or prices more broadly.

     For several years, economists have estimated the level of monthly payrolls

growth consistent with a stable unemployment rate to be around 80,000 to

120,000. Yet jobs growth has exceeded that level, averaging 171,000 a month in

2017 and pulling the unemployment rate down six-tenths of a point over the

course of the year to a 17-year low of 4.1%. The FOMC projects it will fall

further to 3.9% by the end of this year before beginning to rebound in 2020.

--MANY FOMC BELIEVERS

     The minutes of the December FOMC meeting released last week revealed that

many officials expect cyclical pressures to push inflation higher in the future,

though some expressed concern that persistently low inflation could depress

inflation expectations further. 

     Two regional Fed presidents recently urged patience on further interest

rate hikes out of concern that the central bank might send the wrong signal by

pressing on with normalization while inflation was still weak. 

     "I view the possibility that the public believes inflation will

persistently fall short of the 2% objective as a risk," Atlanta Fed President

Raphael Bostic said Monday, citing survey responses as well as market-based

estimates of inflation expectations that indicate people may not be "completely

convinced" about the symmetry of the FOMC's inflation objective. 

     "This possibility is one factor that might argue for being somewhat more

patient in raising rates, even as the inflation rate moves toward the 2%

objective," Bostic said. He supports gradual rate hikes, but the economy may not

need three-to-four a year, he said. 

     Philadelphia Fed President Patrick Harker on Friday similarly signaled a

dovish turn in his view, calling for two rate increases this year, down from the

three he had predicted for 2018 late last year and which remains the FOMC's

median forecast. 

     The fact that policymakers are not seeing a significant acceleration of

inflation means "we have some time" to consider the next rate increase, Harker

said. "It would be helpful if we were able to get inflation not just at 2% but

above it for a while." 

--WILL WAGES RISE?

     If the jobless rate continues to fall, employers could become more reliant

on hiring individuals not actively seeking jobs. The labor force participation

rate for prime age workers, at 81.9% in December, has climbed steadily over the

past two years but remains a full percentage point below its pre-recession

level. That means roughly 3 million fewer men and women between the ages of 25

and 54 are sitting on the sidelines of the labor force compared to in 2007. At

the top of the last expansion in 1999, prime age participation hit a high of

84.6%.

     Whether that type of hiring would lead to wage inflation is an open

question in a rapidly evolving economy. Underemployment actually rose a tenth of

a percentage point to 8.1% in December, suggesting among other things that the

gig economy could become a larger portion of the labor market. 

--RETHINKING POLICY FRAMEWORK

     If the Phillips curve is broken, then policymakers must focus on other ways

to anchor inflation expectations to help meet their 2% objective. Harker last

week joined several other regional Fed presidents, including Chicago's Charles

Evans and John Williams of San Francisco, in urging further study of

alternatives to the current policy framework of targeting 2% inflation. 

     One option, temporary price level targeting, would let Fed officials make

up for years in which inflation is below 2% by overshooting the goal in other

years until inflation averages 2% over the long run. Another method would target

a nominal GDP level to achieve those consistent with 2% inflation. 

     The Fed is by no means ready to change its operating framework in the near

future, but as officials grapple with relatively modest gains in average hourly

earnings and muted inflation, they may proceed more cautiously in tightening

policy this year than in 2017.

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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