By Steven K. Beckner

(MNI) – Minneapolis Federal Reserve Bank President Narayana
Kocherlakota Wednesday warned there may be less slack in the labor
market than the employment data suggest, potentially resulting in more
inflation to which the Fed would have to respond.

The Fed’s policymaking Federal Open Market Committee is charged
with seeking “maximum employment” along with “price stability,” but
Kocherlakota said the FOMC faces “especially large uncertainty” about
the maximum level of unemployment that monetary policy can actually
achieve.

He said the maximum employment level the Fed can expect to attain
through monetary stimulus may well have been reduced (or the
unemployment rate increased) because of a “considerable deterioration”
in labor market efficiency.

Citing the increased difficulty firms are having filling job
openings in the face of reduced labor force participation, Kocherlakota
said some of the high unemployment may be “persistent,” not
“reversible.” If that is the case, he suggested, there is less
justification for further monetary accommodation.

Kocherlakota, who twice dissented against easing measures last
year, said above-target inflation is suggesting that the economy is
closer to “maximum” employment than many think and said the Fed “should
be responsive to such signals.”

Other policymakers, he acknowledged, believe that the kind of
“structural” labor market problems he mentioned are minimal and that
most unemployment is “reversible” and hence are more inclined to support
further monetary easing.

Kocherlakota pointed out that, in its statement of longer-run goals
and monetary policy strategy issued in January, the FOMC said it could
not set an unemployment target because “the maximum level of employment
is largely determined by nonmonetary factors that affect the structure
and dynamics of the job market.”

Kocherlakota emphasized that “the FOMC has no control over these
nonmonetary factors,” including such things as “population trends, the
incentives built into the tax system, the incentives built into social
insurance safety nets, the returns to human capital accumulation for
young people, and simply social norms.”

And he said changes in such nonmonetary factors “generate
fluctuations in the level of maximum employment achievable through
monetary policy — fluctuations that are often hard to gauge on a
real-time basis.”

And so, he said, the FOMC “currently faces an especially large
amount of uncertainty about the level of maximum employment that it can
hope to achieve.”

By way of illustration, Kocherlakota pointed to “a sharp decline”
in the employment/population ratio and to an “accelerated” decline in
the labor force participation rate.

Whereas firms usually hire more workers in a recovering economy, in
the recent period there has been “a decline in the ability of the labor
market to form mutually beneficial matches between workers and firms.”

“In that sense, the labor market is less efficient,” he said.
“Firms can’t fill their available job openings as readily as we would
have expected in light of the high unemployment rate.”

As a result, “labor market outcomes do remain notably worse than
prior to the recession,” he said.

Although the unemployment rate has come down, so has the labor
force participation rate, and there has been “considerable deterioration
in labor market matching efficiency,” he said.

Kocherlakota pointed to research showing that Sweden has suffered a
“permanent” increase in unemployment since its “triple crisis” of the
early 1990s and said “Sweden’s experience forces us to contemplate the
possibility that the erosion in labor market performance that we’ve seen
in the United States over the past five years may be highly persistent,
even under appropriate monetary policy.”

There are important policy implications for the Fed, he said.

The debate over whether labor market changes are “largely
reversible under appropriate monetary policy” or are “likely to be
highly persistent” means that “the FOMC is confronted with an unusually
high degree of uncertainty about the level of ‘maximum employment’ it
can achieve,” he said.

“This uncertainty translates directly into a corresponding
uncertainty about the appropriate approach to policy,” he continued. “In
particular, policymakers who see the deterioration in labor market
performance as reversible using monetary policy will typically favor
more accommodative policy than those who view the deterioration as more
protracted.”

Kocherlakota said that, for him, the inflation rate is key to
determining how close the Fed is to the maximum achievable level of
employment or the minimum achievable level of unemployment. And the
signals are not good, he suggested.

“Inflation was distinctly higher in 2011 than in 2010 and continues
to run above the FOMC’s target of 2%,” he noted. “Even core measures of
inflation, which strip out energy goods and services, and food, went up
notably.”

“I see these changes as a signal that our country’s current labor
market performance is much closer to ‘maximum employment,’ given the
tools available to the FOMC, than the post-World War II U.S. data alone
would suggest,” he said.

And he added, “appropriate monetary policy should be responsive to
such signals.”

** MNI **

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