Tuesday, September 2, 2014

Fed study shows the economy has room for a lot more stimulus

It matters a lot whether Janet Yellen thinks long-term unemployment affects inflation. Getty Images

If you're paying even a little attention to recent news about the job market, you know that long-term unemployment is a problem. The share of Americans unemployed for six months or more (the blue line in the below chart) has become far and away the largest chunk of the unemployed.


A recent paper from the Federal Reserve, however, bucks common thinking on what those differing levels of long- and short-term unemployment do to inflation — and therefore what the central bank might do in the near future.

Broadly speaking, unemployment and lower prices are linked. When fewer people are working, they spend less and increase competition for jobs, meaning employers can pay lower wages. These factors can push inflation downward. (Likewise, lower inflation can create unemployment — when consumers believe prices might go downward, they can be more reluctant to spend now, rather than later.)

Since the crisis, many have questioned whether the two different types of unemployed people have affected prices differently. A March paper by former CEA chair Alan Krueger, along with Judd Cramer and David Cho of Princeton University, suggested that the short-term unemployed may hold down inflation more than the long-term unemployed.

The idea is that the long-term unemployed may be so disconnected from the job market that they aren't affecting wages or inflation in the same way that the short-term unemployed do.

Except that might not be true.

In this paper, Fed economist Michael Kiley found otherwise. Using data from 24 US metropolitan areas, his findings "suggest that long-term unemployment has exerted similar downward pressure on inflation to that exerted by short-term unemployment in recent decades."

The reason this wonky economics debate matters is because it will help determine how much central bankers decide to do to continue boosting the economy. If long-term unemployment really has little effect on price inflation, then central bankers might want to back off their economic stimulus and bring interest rates up, since the long-term unemployed aren't coming back to work at the same rates as their short-term peers.

But if the opposite is true — if people out of work for long periods of time push inflation down just as much as the short-term unemployed, that means that, despite a healing labor market — particularly among the shortest-term unemployed — inflation is likely to remain low, and there's plenty of slack in the job market to be paid out before wages heal.

If that's true, it means much more room for stimulus before rising prices become a problem, meaning the Fed can keep its foot on the gas pedal. And for her part, Fed Chair Janet Yellen has already been a proponent of the idea that long-term unemployment is largely cyclical rather than structural — that is, that it's due to bad economic conditions, rather than a skills mismatch or demographics.

That also signals that she thinks more can be done. The Fed can try to stimulate spending and growth, but it can't do anything about whether workers are qualified enough to get the jobs that are out there.

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