The economy has been sending conflicting signals on two items that matter most to the Federal Reserve.
Steady job gains have pulled down the unemployment rate to lower-than-expected levels, at 4.3% in May, a 16-year low. But inflation, which just a few months ago nosed above the Fed's 2% target for the first time in five years, has unexpectedly slowed.
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Fed officials are putting more emphasis for now on hiring and falling unemployment gauges, which they believe should eventually push inflation higher.
The U.S. economy added 138,000 jobs in May, the Labor Department said Friday. The report showed the unemployment rate ticked down from 4.4% in April largely because of a drop in the number of Americans in the labor force last month.
Fed officials have said they believe the slowdown in inflation in March and April is likely to prove transitory, leaving them on track to raise short-term interest rates at their policy meeting this month to a range between 1% and 1.25%, and pencil in one more rate move this year.
"We have an increasingly tight labor market," said Dallas Fed President Robert Kaplan in an interview Thursday. "The most likely case is we're going to see a gradual, not rapid, but gradual increase in the inflation rate to our 2% objective over the medium term -- over the next couple of years."
Friday's report was mixed. While the Labor Department revised down estimates of job growth in March and April and showed a drop in the labor-force participation rate, it also showed signs of disappearing labor-market slack. The broadest gauge of unemployment and underemployment -- which counts unemployed workers plus Americans too discouraged to actively look for work and part-time workers who would prefer full-time jobs -- fell to 8.4% in May, the lowest level since before the 2007-09 recession.
Average hourly earnings for employees on private nonfarm payrolls rose 2.5% from a year earlier in May, essentially the same pace of wage growth as the month before. While May's report was weaker than the April's, officials have said they aren't likely to put too much emphasis on any one report, preferring to look at trends over time.
The economy is still adding more than enough jobs to keep up with the growth of the working-age population. In March, Fed officials projected the unemployment rate would end the year within a range of 4.4% to 4.7%.
Officials at their last meeting on May 2-3 indicated they were prepared to look past a surprise drop in their preferred inflation gauge in March. Prices rebounded somewhat in April, though prices excluding food and energy slowed to an annual gain of just 1.5%, the lowest since December 2015.
The rebound in April suggests the March decline was "somewhat idiosyncratic," said Mr. Kaplan.
Some of the surprise drop in inflation resulted from one-off factors, particularly steep drops in prices for wireless telephone plans. Rent rises slowed amid a rising supply of luxury apartments, and a glut of used cars has pushed resale prices down.
A weaker dollar and stronger labor market could push prices in the other direction. And officials remain confident that if the unemployment rate holds at its current level or falls further, wage pressures ultimately will assert themselves.
"There are good reasons to expect that inflation will resume its gradual rise," Fed governor Jerome Powell said in a speech Thursday.
Mr. Powell said he expects joblessness to keep declining "and remain at low levels for some time, which could draw more workers into the workforce, put upward pressure on wages, or cause businesses to invest more as labor costs rise, all of which I would view as desirable outcomes."
Moreover, financial conditions have eased this year and global economic growth has firmed.
While officials welcome the economy's gains, they don't want to let it overheat, sending inflation too high. So they are likely to stick with tentative plans to raise rates twice more this year, including at their meeting June 13-14, and to begin to slowly and gently shrink the central bank's $4.5 trillion portfolio of bonds and other assets.
Officials are likely to mark down their expectations for inflation and possibly the unemployment rate in new projections to be released after the meeting. In March, officials estimated that by the end of this year, annual inflation would be 1.9% and the unemployment rate would be 4.5%.
The Fed has held its benchmark federal-funds rate in a range between 0.75% and 1% since lifting it in March.
They will face a more difficult debate over whether to raise rates later this year if inflation remains weak. "It may lead me to reassess the expected path of the federal-funds rate in the future, although it is premature to make that call today," Fed governor Lael Brainard said in a speech Tuesday.
Mr. Kaplan said his view that the inflation slowdown is likely transitory would change if he saw evidence of a hiring slowdown.
For now, officials can reasonably conclude stronger hiring will cancel out softer inflation. If price softness "were to prevail for six months, you're not going to be satisfied with making that back of the envelope judgment," said Krishna Guha, head of central bank strategy at Evercore ISI and former head of communications at the New York Fed.
A more prolonged stretch of weak inflation might indicate inflation expectations had slipped below the Fed's 2% target, and that "would have more far-reaching consequences for the path of policy than anything we've seen today," he said.
Write to Nick Timiraos at email@example.com
(END) Dow Jones Newswires
June 02, 2017 09:52 ET (13:52 GMT)