Economists' Report Says Jobless Rate Of 4.5% Is Ideal to Avoid Inflation
By YOCHI J. DREAZEN Staff Reporter of THE WALL STREET JOURNAL
WASHINGTON -- A new study by three respected economists is fueling debate inside the Federal Reserve while bringing to a head an academic argument that has been brewing for five years. The subject: How low can unemployment go without triggering inflation?
Some members of the Federal Reserve's Federal Open Market Committee, which will conclude its two-day policy-setting meeting here on Wednesday, worry that the nation's tight labor market could soon trigger an expansion-wrecking spiral of rising prices and wages. That is a big reason why some members will continue agitating for further rate increases later in the summer even if -- as is widely expected -- the central bank votes to leave rates alone on Wednesday.
But in a soon-to-be-released paper, three scholars conclude that the jobless rate could long remain as low as 4.5% without a surge in prices. That is higher than the current rate of 4.1%, but well below the consensus of mainstream analysts, most of whom believe that unemployment can't stay below about 5% for long without igniting inflation.
The paper was written by George Akerlof, economist at the University of California-Berkeley; George Perry, senior economist at the Council of Economic Advisors during the Kennedy administration who is now at the Brookings Institution; and William Dickens, former member of the Council of Economic Advisors under President Clinton, now also at Brookings.
The economists believe a long-term jobless rate of 4.5% would push inflation somewhat above its current rock-bottom levels with consumer prices rising at about 3.4% a year, compared with the 3.1% annual rate recorded so far this year.
But they say that prices would then stabilize at that level and wouldn't accelerate, as other economists fear. In fact, they argue that a moderate level of price increases -- not zero inflation -- is the ideal because it allows the maximum number of Americans to hold jobs without threatening the economy.
"We're saying that there's a sweet spot of low but positive inflation that allows you to minimize unemployment," said Mr. Dickens in an interview.
The study will be published next month by Brookings, a liberal-leaning Washington think tank. Early drafts have been circulated and are already stirring controversy inside the Fed.
Fed governor Laurence Meyer, the central bank's chief inflation hawk, is known to vehemently disagree with the paper's findings. He has publicly estimated that the jobless rate can't stay below 5.2% for long without prompting an escalation in inflation -- and has argued that unemployment may even need to climb above that level temporarily to remove the pressures created by jobless rates that have long hovered well below 5%.
Other Fed officials, however, have read the paper and privately cite it as a possible academic justification for plotting a more moderate interest-rate strategy than conventional wisdom would suggest.
The Brookings paper also has reignited a debate in academia over the credibility of the so-called nonaccelerating inflation rate of unemployment theory, or Nairu, which tries to pinpoint the lowest level that unemployment can fall before causing inflation to accelerate.
At some point, most economists believe, emboldened workers begin to demand ever-higher wages, forcing employers to raise their prices to offset the increased labor costs, which in turn sparks demand for still-higher wages to cover the rising cost of living.
For years, economists believed the danger point for unemployment was about 5.5%, nearly a point lower than its level in the 1980s. But the jobless rate fell below that level in June 1996, then below 5% in May 1997 and touched a 30-year low of 3.9% in April. In May, it inched back up to 4.1%. All the while, inflation has remained tame and, for a time, even fallen.
While even the most cautious economists believe the Nairu has declined in recent years, few believe that it has fallen all the way to 4%.
Government numbers crunchers at the Congressional Budget Office and the White House Office of Management and Budget, for example, estimate that a jobless rate of 5.2% is the lowest that can be sustained over the long term, an opinion widely shared among private-sector economists. President Clinton's February budget proposal direly noted that its "forecast for real growth over the next three years implies that unemployment will return to 5.2% by the middle of 2003."
Despite the economy's ability to blend low inflation with low unemployment in recent years, skeptics argue that price increases have been kept under wraps by a variety of temporary factors, including falling import prices and a one-time surge in productivity.
In a recent speech in New York, outgoing Fed research director Michael Prell warned that the labor market "is overly tight and [the] 4% [jobless rate] is not going to prove sustainable." He added that the current threshold was probably lower than it was in the past, but questioned whether recent changes in the economy are "really a night-and-day difference than other periods."
The issue isn't just academic. Assuming the size of the labor force remains constant, pushing the jobless rate up to 5.2% would mean that nearly 1.2 million additional Americans would find themselves without work. The paper argues that such job losses would be unnecessary. "What we've seen in the economy for the past few years isn't a fluke," Mr. Perry says.
The authors say that the economy can sustain lower jobless rates now than had long been assumed because of the nation's recent bout of low inflation. Conventional wisdom asserts that workers demand higher wages to make up for losses from inflation, which erodes their real wages by requiring them to spend more of their salaries on the same goods, as well as to offset their expectations of future price increases.
But when inflation is low -- a term the authors apply even to inflation rates above 3% -- the paper argues that workers tend to ignore the price changes as meaningless statistical noise, and thus don't demand higher wages. As a result, companies can avoid having to raise their prices, helping to keep inflation from accelerating further.
Several other analysts, while agreeing that the economy can sustain lower unemployment rates than in the past, question the paper's assumption that workers and firms ignore moderate levels of inflation.
"Firms and workers are keenly aware of inflation even when it is low, particularly when inflation for very visible and frequently purchased goods and services, like gasoline, changes significantly," says Mark Zandi, chief economist with RFA-Dismal Sciences in West Chester, Pa.
With salary comparisons and financial information readily available in the media and over the Internet, he adds, "workers are even more aware of their real wages than in the past."
For their part, the authors emphasize that it may be impossible to precisely determine how low the unemployment rate can go without triggering inflation. Still, they argue that current levels may not be that far off.
"I think we're certainly in the right neighborhood," Mr. Perry says. "I would say that the unemployment rate is settling down fairly close to what is optimal."