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Tuesday, March 13, 2007

FRBSF: The Economic Outlook

Interesting graph from the San Francisco Fed on the relationship between unemployment and wage inflation:

Frbsf313079a

The accompanying write-up says:

Conventional wisdom holds that when the unemployment rate falls below the NAIRU, wage inflation increases, which eventually feeds through to price inflation. A key question for policymakers is whether this conventional wisdom remains relevant today.

There are a number of potentially mitigating factors that might temper the relevance of this historical relationship. Three factors that have received particular study of late are: (1) mismeasurement of available workers, (2) mismeasurement of the NAIRU, and (3) changes in the sensitivity of wage inflation to the unemployment rate owing to the rising importance and stability of inflation expectations.

Although the measured unemployment rate is quite low, some would argue that it does not fully capture the population available for work. Relative to the late 1990s, the labor force participation rate (LFP) and the employment-to-population ratio remain low, suggesting that there is some room for the total workforce to expand. On the other hand, the aging of the baby boom makes the return to past peaks in LFP or the employment-to-population ratio less than certain.

The NAIRU is difficult to measure and is affected by a number of demographic and institutional factors. There is a wide range of credible estimates of the current NAIRU—4.7 to 5.2—suggesting that labor markets may not be quite as tight as the consensus estimate would imply.

The sensitivity of wage inflation to the unemployment rate depends in part on the inflation expectations of workers. Despite elevated levels of price inflation of late, inflation expectations remain well-contained, likely tempering the magnitude of cost-of-living based wage increases demanded by workers.

The graph is part of the latest Economic Outlook from Mary C. Daly, vice president FRBSF. The entire report is on the continuation page:

Economic Outlook, by Mary C. Daly, Fed Views, FRBSF: Mary C. Daly, vice president at the Federal Reserve Bank of San Francisco, states her views on the current economy and the outlook:

Frbsf313071

As expected, real GDP growth for the fourth quarter of 2006 was revised down substantially from the advance release. GDP grew 2.2 percent in the fourth quarter of last year, well off the 3.5 percent pace reported in the advance estimate. GDP growth was restrained by declines in motor vehicle production and residential construction.

Turning to data for January, the news has been mixed but generally consistent with weaker momentum in the short term.

Frbsf313072

On the negative side, orders for durable goods posted large and broad-based declines in January. Manufacturing and industrial production also weakened and manufacturing capacity utilization fell. That said, the ISM survey of manufacturers rose above 50 in February, indicating expansion in the sector going forward.

On the positive side, consumer spending outside of autos and homes remains quite strong; real personal consumption expenditures rose a healthy 0.3 percent in January. Real disposable income growth also increased, suggesting that the consumer sector remains very healthy.

Recent readings on the housing market data have been mixed but, on balance, provide some tentative signs of a prospective stabilization. Sales of existing homes were up sharply in January. On the other hand, sales of new homes were weak. Housing starts were down and the value of overall construction put in place declined in January relative to December, but data on housing permits appear to have leveled off in recent months.

Frbsf313073

Turning to labor markets, job growth has edged down in recent months.

Frbsf313074

Still, labor markets remain relatively tight—unemployment in January was 4.6 percent and data on job openings point to future strength in hiring.

Frbsf313075

Turbulence in global and U.S. financial markets left equity markets down from recent highs. However, the declines have been modest relative to increases over the past 15 months, and values in equity markets remain high.

Incoming data suggest continued moderate growth in real GDP during the first half of this year. As the damping effects of weaker housing and domestic auto production wane, growth is projected to accelerate, reaching around 2-3/4 percent in the second half of this year.

Frbsf313076

In 2007, with real GDP expected to grow a little less than potential and with the unwinding of a variety of temporary factors that boosted inflationary pressures last year, the level of core inflation is expected to edge down during the course of the year. However, the low level of the unemployment rate remains an upside risk to this inflation projection.

Frbsf313078

Weakness in incoming data and turbulence in global and domestic financial markets have pushed down the expected path of the federal funds rate. About 50 percent of market participants expect a rate cut at the June FOMC meeting.

Frbsf313077

As noted, the low level of the unemployment rate is a noted upside risk to inflation. This concern arises from the historical relationship between the measured unemployment rate, the non-accelerating inflation rate of unemployment (NAIRU), and wage inflation.

Frbsf313079

Conventional wisdom holds that when the unemployment rate falls below the NAIRU, wage inflation increases, which eventually feeds through to price inflation. A key question for policymakers is whether this conventional wisdom remains relevant today.

There are a number of potentially mitigating factors that might temper the relevance of this historical relationship. Three factors that have received particular study of late are: (1) mismeasurement of available workers, (2) mismeasurement of the NAIRU, and (3) changes in the sensitivity of wage inflation to the unemployment rate owing to the rising importance and stability of inflation expectations.

Frbsf3130710

Although the measured unemployment rate is quite low, some would argue that it does not fully capture the population available for work. Relative to the late 1990s, the labor force participation rate (LFP) and the employment-to-population ratio remain low, suggesting that there is some room for the total workforce to expand. On the other hand, the aging of the baby boom makes the return to past peaks in LFP or the employment-to-population ratio less than certain.

The NAIRU is difficult to measure and is affected by a number of demographic and institutional factors. There is a wide range of credible estimates of the current NAIRU—4.7 to 5.2—suggesting that labor markets may not be quite as tight as the consensus estimate would imply.

The sensitivity of wage inflation to the unemployment rate depends in part on the inflation expectations of workers. Despite elevated levels of price inflation of late, inflation expectations remain well-contained, likely tempering the magnitude of cost-of-living based wage increases demanded by workers.

    Posted by on Tuesday, March 13, 2007 at 11:58 AM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (7)

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