Deciphering labor markets will be hot topic at Jackson Hole

The Federal Reserve holds its annual meeting in Jackson Hole this year with substantial questions about the outlook for the labor market, inflation and the path of interest rates.

Close attention will be paid to the Friday morning speech by Fed Chair Janet Yellen—her first at Jackson Hole as head of the central bank—who will focus on the main subject of the conference, labor markets.

With the Fed still maintaining an ultra-low zero interest rate policy, the critical issue is how much slack there is in the form of the unemployed, those working part-time because they can't find full-time work and those who have stopped looking for work.

Mount Moran in Grand Teton National Park is seen through a window at the Jackson Lake Lodge in Moran, Wyoming.
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Yellen and several others on the interest-rate setting Federal Open Market Committee have maintained that there are millions of Americans who can and will work if jobs are available. The cadres of unemployed and underemployed Americans are expected to exert downward pressure on wages, even if growth heats up, once they are brought back into the workforce. That should keep a lid on the Fed's main concern, inflation, which should allow it to keep rates at zero for what it calls "a considerable period" after it stops buying assets through its quantitative easing program, perhaps until mid-2015.

The market largely buys this line of reasoning, or at least believes it's the one that the Fed will follow. Wall Street expects the Federal Reserve to be so dovish that the coming round of interest rate hikes won't begin until mid next year and won't end until the next president of the United States is in office for nearly a year.

A special CNBC Fed Survey, prepared ahead of the central bank's annual meeting in Jackson Hole, shows that market participants expect the coming rate hike cycle to end in the fourth quarter of 2017 at 3.16 percent. That would be the lowest final or terminal rate ever. It would beat the next lowest—the rate hikes in 2004 through 2006 that ended at 5.25 percent—by more than two full percentage points. It would also be the longest rate-hike cycle since at least 1983.

Read MoreWall Street expects really dovish Fed on rate hikes: Survey

But there's another view on labor markets that will surely be discussed by monetary policy makers here: that labor markets are far tighter than the Fed believes. The work of Alan Krueger, a Princeton economics professor, who was invited to the conference but couldn't attend, will loom large. The former top economic advisor to President Barack Obama has written several research papers since leaving the White House suggesting the long-term unemployed are not coming back to work.

The main influence of labor markets on inflation, Krueger argues, is from the short-term unemployed and their rate of unemployment is now back to normal. The fear is that a normal short-term unemployment rate mixed with a zero Fed funds rate is a toxic brew that could spark inflation.

Apart from the labor market debate, another area of concern is whether the low funds rate has prompted vast misallocation of capital and created bubbles in a variety of asset classes that could risk another financial crisis. Harvard economist Martin Feldstein, writing recently in the Wall Street Journal with former Treasury Secretary Robert Rubin, raised concerns that "low yields on Treasury bonds have led to reaching for yield in many ways and in very large magnitudes."

While the two said that doesn't necessarily mean there are asset bubbles, they warned that "the combination of their dramatic increase in price, the low volatility and the reaching for yield by investors and lenders suggest that the risk of excesses and the consequent instability have increased substantially."

Yellen has suggested that interest rates need to be set at the right level for the broader economy. If they create bubbles that endanger growth, she hasn't ruled out addressing the problem with interest rates, but suggests the preferred first response is for regulation to deal with the problem either by prompting banks to shed risky assets or boosting reserves and capital to buffer the banks from losses.

Read MoreFive reasons the Fed should raise rates now

Feldstein and Rubin, however, have there doubts about whether these so-called "macro prudential tools" are up to the task. "Our conclusion is not that the Fed should respond to those risks by raising interest rates now," the two wrote. "Weak labor markets are and should be a deep concern and a pressing issue. But the Fed should also take into consideration the possibility of excesses brought on by low interest rates that could create financial crises."

While the debate in the U.S. is about when and by how much to raise rates, in Europe the question is how they can ease monetary policy further to respond to very weak economic numbers. Close attention will be paid in Jackson Hole to a Friday afternoon speech by European Central Bank President Mario Draghi. Among other things, he could be expected to signal rates will stay low for a longtime in Europe and perhaps provide new details on the ECB's plan to inject new liquidity in the economy thought a plan to provide low-cost financing through asset-backed securities.

Read MoreWhat traders expect from the Fed this week

The outlook is critical in the U.S., where weak economic growth globally is expected to keep a lid on growth here. But overall, compared with previous years, less debate is expected on the growth outlook. There is general consensus that the U.S. economy has a reasonable floor at around 2 percent, with the main question being whether it can grow as strongly as 3 percent. Few seem to believe that 4 percent is in the cards.

—By CNBC's Steve Liesman