• The U.S. job machine slowed in May (+138k jobs) as the unemployment fell to a sixteen year low of 4.3%. A pullback in the participation rate contributed to the fall in the unemployment rate.
  • The Federal Reserve’s preferred measure of price growth slowed in April to 1.7% (from 1.9%), while the core measure fell to 1.5% (from 1.6%).
  • Weak inflation will probably not forestall a rate hike in June, but continued weakness could be enough to delay further rate hikes. Just as much as job growth, this is an important metric to watch for guidance on future Fed action.


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The Federal Reserve has a conundrum. Its dual mandate is for maximum employment and price stability. On the latter, inflation has remained stubbornly below its 2% target. In April, the Fed’s preferred core inflation measure slowed to 1.5% from a recent peak of 1.8% in February.

On the former however, it’s becoming harder and harder to argue that the American economy is not nearing full employment. In May, the unemployment rate ticked down to 4.3% – its lowest level in sixteen years. Broader measures of unemployment, such as the U6 (which adds marginally attached workers and involuntary part-timers to the tally) also fell to 8.4% – its lowest level in nearly a decade.

In theory, a tightening labor market should be putting upward pressure on inflation. But, as noted by Federal Reserve Governor Brainard in a speech this week, even while the unemployment rate has fallen over five percentage points since the end of the recession, inflation has moved little. Headline consumer price growth has ebbed and flowed with energy prices, but core price measures have maintained a modest rate of change, notably under 2%.

There are a few ways to square this circle. The first, as referenced by Brainard, is that well-anchored inflation expectations have reduced the impact of economic slack on inflation. In economics jargon, the slope of the Phillips curve may still be negative (inflation rises as unemployment falls), but it has flattened.

A second explanation is that even as unemployment has fallen, so has the theoretical unemployment rate associated with full employment. On this front, the median projection for the long-term unemployment rate among FOMC members has moved consistently downward. Given the recent moves in unemployment and inflation, there is a good chance that it will do so again in June. There is a good argument that an aging population puts downward pressure on the natural rate of unemployment. One can see this dynamic in Japan where the measured unemployment rate is at an all-time low, yet the economy continues to be plagued by deflation.

A third explanation is that the unemployment rate is no longer an accurate measure of labor market slack. While the more inclusive measures have also been falling, the still-limited rebound in core-age participation rates suggests more slack may exist. Alongside a potentially lower natural unemployment rate, this larger “shadow” gap could be diluting the inflationary impact of the tightening labor market.

A fourth explanation is that even while the U.S. labor market is tightening, a consistent and possibly expanding level of global economic slack is keeping downward pressure on inflation. With the Federal Reserve more responsive to domestic than global conditions, rate hikes to-date have put upward pressure on the dollar and helped to import global disinflation into America.

Putting it all together, the improvement in the labor market may provide the impetus for the Federal Reserve to continue to raise interest rates, especially if productivity remains weak and it is satisfied that wage growth is moving higher. Still, it cannot ignore the inflation side of its mandate. Continued underperformance on the inflation front will strengthen the case for patience and likely lead the Federal Reserve to slow the pace of rate hikes.

James Marple, Senior Economist

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