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Federal Reserve officials are debating a historic shift in one of its core economic gauges that could lead the central bank to move even slower than now thought once it lifts its rates from rock bottom levels.
According to interviews with half a dozen current and former Fed policymakers and staff, the concept that the economy can produce far lower levels of unemployment without stoking inflation is being built into Fed models and becoming increasingly entrenched in the central bank's views.
That shift may not delay the timing of the Fed's first rate increase, still expected in mid-year. But it does offer Chair Janet Yellen a good reason to move at a snail's pace from then on to bring as many people as possible back to work and to push inflation back up to the Fed's 2-percent target.
Fed policymakers' December projections show most expect the Fed's benchmark rate to rise to 2.5 percent or above by the end of 2016 from the 0-0.25 percent range now.
On Monday, Fed governor Jerome Powell became the latest of policymakers to suggest the "natural" rate of unemployment, also referred to as a level of full employment, had fallen.
"Maybe the natural rate is lower...That it is five (percent) or even lower," Powell said. That would be significantly below current unemployment rate of 5.7 percent and the 5.2 percent to 5.5 percent range Fed officials have recently estimated as the level of unemployment at which inflation is likely to increase.
Atlanta Fed President Dennis Lockhart said the question of the true level of full employment will come into focus when the Fed will have to decide whether to allow unemployment to drift to unusually low levels to push inflation toward its target.
"I am quite open to the idea that the destination we are trying to get to is lower than we have cited in the past," he said on Friday.
The chiefs of the Boston Fed and the Minneapolis Fed have also said they are considering lowering their estimates, as did several staff at other Fed branches who declined to be quoted, in line with the central bank's policy for briefing the media.
For months, Fed policymakers have been puzzling over how the accelerating economy kept adding jobs but failed to spur wage and price increases that would cement the recovery and allow them to wind-down crisis era policies.
Now, there is growing sense that the point where the job market tightens enough to start pushing up wages and prices may be further away than earlier thought.
The U.S. central bank has no official target for full employment—generally expressed as the unemployment rate that is consistent with stable prices. But accurately estimating it is critical for the Fed, given its mandate is to safeguard economic conditions that allow maximum employment consistent with stable prices that the bank defines as 2 percent inflation.
Since the 1960s estimates of that "natural rate of unemployment" have averaged 6.3 percent, according to data published quarterly as part of the Fed's main economic model.
Beginning in 2013, however, its staff has been marking that rate down, from 5.6 percent to 5 percent by late last year. That may lead regional Fed presidents and board members to cut their quarterly estimates due next month.
Research at several Fed banks, both published and unpublished, puts the estimate as low as 4.7 percent.
The possible reasons, according to Fed policy makers and staff, range from a structural downshift in growth, an aging workforce less likely to job-hop, and the sense that there are many people willing to rejoin the labor force and work for less.
Another explanation is the rise in the number of workers who choose to work part time, which helps lower both labor costs and the unemployment rate.
Many economists now also believe that low inflation expectations are so deeply rooted they act as a cap on wages and prices.
Those policymakers and Fed researchers who estimate a lower "non-accelerating inflation rate of unemployment" believe those and other scars of the 2007-2009 financial crisis have allowed the unemployment rate to slide from 10 percent without much evidence of a run-up in wages or prices.
Despite an addition of a million jobs between October and December, wages in the 12 months to December rose just 2.2 percent, a historically slow pace.
"Wage inflation has been well below the level that would be consistent with 2 percent price inflation," Powell said. Wage growth, he said, would need to accelerate to perhaps 3.5 percent—the target inflation rate plus the expected increase in productivity—before it nudges up inflation.
Shift is not yet sealed
Not all Fed policymakers have changed their minds, however. Cleveland Fed President Loretta Mester, for example, said last week she was sticking with her current estimate of 5.5 percent.
Coming out of the recession, Fed policymakers were jacking up their estimates of the normal jobless rate to account for growing ranks of long-time unemployed who might lack skills sought by employers.
But as unemployment plunged with no sign of wage or price rises, they shifted those down. For example, San Francisco Fed President John Williams—a policy centrist with views largely aligned with those of Yellen - recently put his estimate at 5.2 percent, while two years ago he thought it was around 6 percent.
Even so, Williams has in his past research warned against relying too heavily on estimates of the natural rate to dictate policy because of the uncertainty around those estimates.