News Analysis: Job gains, low inflation pose dilemma for Fed's interest rate rise

The August jobs report released Friday morning highlighted a policy dilemma for U.S. Federal Reserve officials as they debate whether to raise interest rates for the first time in nearly a decade at its policy meeting later this month.

The U.S. labor market has shown steady progress in the past year, with employers adding over 247, 000 jobs a month on average and the unemployment rate dropping to a seven-year low of 5.1 percent in August, according to the report released by the Labor Department. The unemployment rate is now in the middle of the range that Fed officials consider as the level of full employment.

As the economy approaches full employment, wage pressures will start to rise and push up inflation towards the central bank's 2 percent target, based on standard economic theory. This gives Fed officials reasons to consider raising interest rates to prevent the economy from overheating.

But the modest wage growth and persistently low inflation rates suggest that underlying slack remains in the labor market and there's little reason to worry much about inflation. Average hourly earnings rose by 8 cents to 25.09 U.S. dollars in August and were up only 2.2 percent over the past 12 months.

The so-called core PCE (personal consumption expenditures) price index, a measure of core inflation excluding food and energy, increased only 1.2 percent in July from a year ago. That has persistently run below the Fed's 2 percent target for over three years and given Fed officials reasons to wait longer and avoid the error of tightening policy too soon.

"The fact that inflation hasn't risen and wage gains haven't picked up wouldn't hold me back entirely, but they do make me hesitate a little bit to move (interest rates) sooner rather than later," former Fed vice chairman Donald Kohn said Thursday during a panel discussion about the Fed's monetary policy at the Brookings Institution.

"It will be a little assuring if you saw a little more (inflation) there," Kohn said, adding that the recent turbulence in global financial markets and the slowdown in emerging market economies also made the Fed less likely to raise interest rates in September.

Global financial markets have experienced a storm in the past few weeks, with stocks, commodities and emerging market currencies selling off sharply.

"Is this volatility telling us something that the economy is fundamentally weaker so that I can't have confidence that the inflation is going to return to the target?" asked Jon Faust, professor of economics at Johns Hopkins University and former special adviser to the Fed's board of governors, who was also at the panel discussion.

"That's the question we don't really understand very well. There will be an intense discussion about that," he noted.

In Faust's views, Fed officials will also debate at its next policy meeting on Sept. 16-17 whether the labor market will continue to improve to give them confidence that inflation will move back to 2 percent.

"Everybody, I think, believes that at some point as the labor market tightens it will provide upward pressures on inflation...Almost everybody believes we're getting near that point. So that's where the debate is, how close we're to that point," he said.

Julia Coronado, chief economist at Graham Capital Management, believed a slowdown in global economy and the low inflation environment around the world have undermined confidence among Fed officials that inflation will move back to 2 percent over the medium term, therefore reducing the probability of a September interest rate hike.

Coronado said it would be "a big surprise for the market" if the Fed actually raises interest rates this month. "If they move in September, it would tell us that they're not weighting the global development very strongly, they're not weighting inflation disappointment very strongly, they're weighting the labor market much more strongly," she said.

The Fed has said it will raise interest rates when it is "reasonably confident" that the inflation rate will rise again to 2 percent and it would not want to surprise the market.

Portfolio managers would regard it as "a policy mistake" to some extent if the Fed starts raising interest rates in September, Coronado said, noting that the timing does matter very much to the financial market.

The Institute of International Finance (IIF), a leading global association of about 500 financial institutions, has shifted its expectation for Fed's interest rate rise to the fourth quarter of the year.

"We share the view that a September liftoff is now less likely, in the context of tighter and still fragile financial market conditions and a moderately lower inflation trajectory, and we have shifted our baseline expectation to the fourth quarter," the IIF said in a Global Economic Monitor report released Wednesday.

"If the market turmoil continues, the Fed certainly will delay the decision (of raising interest rates)" because there's no imminent threat of inflation, Charles Collyns, managing director and chief economist at the IIF, told Xinhua. "There's no need to go in September. They can certainly wait."

"On the other hand, I think they do want to begin the process of normalization when conditions are appropriate," Collyns said, adding that an improving U.S. economy and a tightening labor market has made the Fed uncomfortable with keeping short-term interest rates near zero for about seven years. "But it's not going to be impatient. It will wait for the right moment."

Most Fed officials and economists still want the central bank to raise interest rates before the end of this year. "If I didn't raise (interest rates) in September, I would put on the table very strong expectation that rates will go up. I would retain the wording about later this year," said Kohn. Endit