Federal Reserve weighs interest rate hike as employment rises

"The Fed's idea" of long-term unemployment "is somewhat self-fulfilling, and is another reason to err on the side of expansionary policy," says Laurence Ball, an economist at Johns Hopkins University in Baltimore who's researched the natural rate. "If the Fed guides unemployment to 5.3 percent and keeps it there, that may become established as the sustainable level of unemployment."

The absence of any inflationary pressure suggests there is still considerable slack in the job market, said Gary Burtless, a Brookings Institution economist in Washington who previously was with the U.S. Labor Department.

The Fed's preferred measure of inflation, based on consumer spending, rose 0.2 percent in January from a year earlier, the smallest 12-month gain since October 2009. The gauge hasn't been above the central bank's 2 percent goal since March 2012.

"Where's the acceleration that is supposed to accompany our declining unemployment rate?" Burtless said.

One official who's skeptical of that view is James Bullard, president of the St. Louis Fed. He's worried the Fed will err on the side of keeping rates low for too long, and he predicts unemployment will fall below 5 percent in the second half of the year.

"The last two times that we've had unemployment go below the natural rate" were "associated with a bubble," Bullard said in a Bloomberg News interview in New York in January. In 2007, pushing the federal funds rate down "ended in global macroeconomic disaster."

Bullard favors moving more quickly than most of his colleagues to raise interest rates, saying "the die is already cast" that unemployment will go below the rate that is consistent with stable inflation.

Mixed signals

William Dickens, a visiting scholar at the Boston Fed, isn't so sure, saying "there are mixed signals as to whether we are at full employment."

While his research indicates "we are at the natural rate now," the lack of certainty suggests holding off on rate increases, said Dickens, a Northeastern University professor and Brookings Institution senior fellow.

"Don't fire until you start seeing real signs of price inflation, there is sufficient uncertainty" about where full employment is, he said.

Robert Hall, an economics professor at Stanford University in California and chairman of the National Bureau of Economic Research committee that determines when recessions begin and end, said the "ambiguous results" from research on the natural rate of unemployment call for Fed restraint.

"We will be feeling our way toward the lower limit on unemployment," he said. "The Fed should not tighten based on falling unemployment, but rather on rising inflation forecasts, something that hasn't clearly happened yet."

–With assistance from Catarina Saraiva in Washington and Matthew Boesler in New York.