Bernanke's Conundrum: Job Market Refuses to Slow With Economy

Bernanke's Conundrum: Job Market Refuses to Slow With Economy
Bloomberg, 2007-01-30
By Scott Lanman

Call it the Federal Reserve's new conundrum: If the U.S. economy has slowed as much as some data suggest, why is the labor market still so strong?

Chairman Ben S. Bernanke and his colleagues are debating the significance of an unemployment rate that's near a five-year low and 2006 job growth that's almost as strong as the prior year's. Either the labor market is lagging behind the slowdown by a few months, or the economy is stronger than official numbers suggest.

Better-than-forecast growth would increase the danger that the Fed, whose policy makers meet today and tomorrow to set interest rates, will lose ground in its fight against inflation. San Francisco Fed President Janet Yellen, calling the situation a ``puzzle,'' says there's a ``serious risk'' of faster price increases.

``The labor market has proved surprisingly tight in the face of what has been a decent slowing in growth,'' said Bruce Kasman, chief economist at JPMorgan Chase & Co. in New York, who predicts the Fed will raise interest rates by year-end. It's the ``key issue in the inflation outlook.''

Minutes from the Fed's last Open Market Committee meeting cited the labor market as members' chief inflation concern, and economists expect a similar signal in the Fed's statement tomorrow. The strength in employment is dashing some investors' hopes of a rate cut anytime soon.

Last month, policy makers left their benchmark lending rate at 5.25 percent for the fourth straight meeting after ending two years of increases in August, betting that economic growth was slowing enough to bring inflation down. All 107 economists surveyed by Bloomberg News forecast the Fed will again leave the rate unchanged.

`Gangbusters'

There is little dispute among Fed officials and economists about the demand for labor. Yellen, 60, told an audience in Scottsdale, Arizona, on Jan. 17 that the labor market is ``going gangbusters,'' language she repeated in Reno, Nevada, five days later.

Employers last month added 167,000 workers, capping a year in which growth averaged 153,000 a month compared with 165,000 a month in 2005. The December unemployment rate of 4.5 percent was the lowest year-end level since 2000 and was down from 4.9 percent a year earlier.

The chief U.S. economic-growth indicator has been giving the opposite signal. Expansion in gross domestic product slowed to a 2 percent annual pace in the third quarter from 2.6 percent in the three months through June and 5.6 percent in the first quarter.

Expanding Economy

The signal may change this week. The government's initial estimate of fourth-quarter GDP, to be published tomorrow, will show growth accelerated to a 3 percent rate at the end of 2006, according to the median estimate in a Bloomberg survey of economists.

Economists raised their predictions this month after higher- than-forecast retail sales and a narrower trade deficit bolstered the notion that the economy may be in better shape than earlier figures indicated.

``This disconnect story looked much more compelling several weeks ago, when the fourth quarter looked weaker,'' said former Fed Governor Laurence Meyer, now vice chairman of forecasting firm Macroeconomic Advisers LLC in Washington.

Labor Costs

A report tomorrow from the Labor Department may show its employment cost index, a measure of compensation costs, rose 1 percent from October to December for the second straight quarter, the fastest pace in more than two years. That comes as average hourly earnings last month jumped 4.2 percent from a year earlier, a gain last exceeded in 2000.

Yellen says she doesn't consider such readings troubling. Over the past year, increases in the employment cost index have been ``remarkably restrained,'' she said in her January. 22 speech. Overall, the labor market shows ``at best a mixed picture'' and the situation is more likely to be ``benign,'' she said.

One economist who agrees is Jim O'Sullivan of UBS Securities LLC in Stamford, Connecticut.

``We do think ultimately that growth is going to weaken enough to push unemployment up,'' he said. ``I don't think there's any doubt that if real GDP stayed as weak as 2 percent, that the unemployment rate will start going up.''

UBS expects the jobless rate to rise to 5.1 percent in the fourth quarter and real GDP to increase at a 2.2 percent rate for the full year.

This would ease the Fed's main inflation concern. Other economists reckon unemployment is likely to fall.

`Tight Resources'

``If the unemployment rate falls further, as I'm thinking, later on this year, that will create additional tight resources; workers will demand greater wages; and that can push up inflation in the future,'' said Christopher Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. ``That's why the Fed would want to restart its rate hikes.''

Some economists say the job market's strength may not be a puzzle at all; instead, it could be evidence that borrowing costs are still low enough to stimulate investment. In fact, this conclusion is shared by analysts with opposing views on whether there's a tradeoff between inflation and unemployment.

``When the Fed gets easy, typically, but not always, you'll see a tightening labor market and a more rapidly growing economy,'' said Brian Wesbury, chief economist at First Trust Advisors LP in Lisle, Illinois, and a former economist for Republicans in Congress.

Assistance From Fed

Jared Bernstein, an economist at the union-backed Economic Policy Institute in Washington, said the Fed's rate stance is ``absolutely'' helping the labor market by not being too restrictive.

The extent to which the job market's tightness generates inflation may depend on something outside the Fed's control: productivity. Richmond Fed President Jeffrey Lacker, the only official to publicly favor higher interest rates in the second half, said on Jan. 19 that productivity growth will keep any wage-inflation in check.

Bernanke, 53, doesn't see a productivity slowdown yet. He said in an August speech that ``strong'' growth in productivity will probably go on for ``some time'' as companies make better use of computers to raise workers' per-hour output.

``The key unknown is projections of what productivity is going to be,'' said New York University economics professor Mark Gertler, who taught Lacker in the early 1980s at the University of Wisconsin and has collaborated on research with Bernanke. ``The economy can weather high wage adjustments if they're accompanied by high productivity growth.''