MNI INTERVIEW: Fed Economist Sees Only Modest Inflation Uptick

By Jean Yung

     WASHINGTON (MNI) - The U.S. labor market is overheating less than at

similarly late stages of previous economic cycles, suggesting that trend

inflation may rise only modestly above the Fed's 2% goal over the next year,

Cleveland Fed economist Randy Verbrugge said in an interview Friday,

     Unemployment is currently roughly 0.8 percentage point below the neutral

level at which it would exert neither upward nor downward pressure on inflation,

a gap only about half that of the late-cycle extremes in 2000 and 2007,

Verbrugge and Virginia Tech economist Richard Ashley wrote in a Cleveland Fed

working paper published this month. This would correlate to a 12-month trimmed

mean PCE inflation rate of around 2.2% one year from now.

     "The extra heat is notable, but frankly, modest," compared to some previous

recoveries, Verbrugge said.

     Muted inflation pressures, with inflation languishing below the Fed's

target despite unemployment at a 50-year low, are a key reason why FOMC

officials see no need to raise or lower the target fed funds rate from its

current range of 2.25% to 2.50%.

     --PHILLIPS CURVE NOT DEAD

     But Verbrugge and Ashley's research indicates policymakers should not be

complacent on inflation simply because the Phillips Curve linkage between labor

slack and prices seems to have disappeared during this long slow recovery. Using

the latest econometric tools, they demonstrate that the relationship varies

across the business cycle, and that it is in the latter stages of an expansion

that there is most danger of inflation overshooting.

     Whereas there is weak correlation of low unemployment and inflation during

the "long middle" of a recovery, the effect gains strength in the "hot finish."

     Similarly, while standard models predicted sharp and prolonged disinflation

at the beginning of the Great Recession, as the unemployment rate was so high

for so long, core inflation remained positive for years. Verbrugge's research

shows that shortly after the unemployment rate peaks, the correlation between

inflation and the unemployment gap vanishes. In other words, there was an

initial drop in inflation but no continued downward pressure.

     "Thus, if one does not take this fact into account when examining the

statistical relationship, then the Phillips curve relationship looks weak and

also looks like it weakened notably during the Great Recession, while Rick

Ashley and I reach a very different conclusion," he said.

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

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