Yellen's Inflation Lecture More Than Just an Exercise for Fed

Federal Reserve Chairwoman Janet Yellen speaks Thursday at the University of Massachusetts Amherst on an economic topic--inflation dynamics and monetary policy--that has major implications for the debate over when the central bank should begin raising short-term interest rates. The Fed decided last week to hold rates near zero in part due to uncertainty about how volatility in financial markets could affect the outlook for the U.S. economy. The Fed also repeated that it wants to wait until officials are "reasonably confident" inflation will move back to the central bank's 2% annual target. U.S. inflation has been subdued for years, and there has been little sign of a sustained broad pickup in either wage or price growth. Most policy makers, however, expect the Fed will raise rates in either late October or mid-December. One reason: Ms. Yellen and other key officials at the central bank believe that as unemployment continues to decline, a tighter labor market will start to send inflation higher. The late economist A.W. Phillips charted a relationship between unemployment and wages, often called the Phillips curve, and the theory remains popular among economists even though the actual link between unemployment and inflation has proved elusive for several decades. A stronger dollar and a decline in energy prices have put "a bit of further drag on inflation that I would view as transitory," Ms. Yellen said last week during her post-meeting news conference. But, she added, "a tighter labor market, a labor market moving toward full employment, is one that historically has generated upward pressure on inflation." Ms. Yellen said that if the Fed keeps rates low for too long and the labor market tightens much more than expected, "eventually we will find ourselves with a substantial overshoot of our inflation objective and then we'll be forced into a kind of stop-go policy. We will have pushed the economy so far it will have become overheated, and we will then have to tighten policy more abruptly than we like." Ms. Yellen's lecture at UMass Amherst is scheduled to begin at 5 p.m. EDT. Below is a selection of recent Fed research on inflation, including several papers recently cited by Ms. Yellen and other policy makers. Catching Up From Jackson Hole Ms. Yellen skipped the Kansas City Fed's late-August economic symposium in Jackson Hole, Wyo. This year's conference, though, was on the same topic as her Thursday speech: inflation dynamics and monetary policy. Four research papers presented at the conference addressed different facets of the inflation picture. One looked at the power of financial conditions to help shape the behavior of business prices in unexpected ways. A second played down the relative influence of moves in the dollar on overall U.S. inflation. A third urged central bankers to embrace the complexity of inflation dynamics and stop seeking simple approaches to monetary policy. A fourth looked at differences among the U.S., Japan and the eurozone as central banks in all three major economies confront stubbornly low inflation. Finding the Curve Ms. Yellen considers the Phillips curve a "coherent and useful framework for thinking about the influence of monetary policy on inflation," as she put it in 2010. But the simple mathematical relationship between unemployment and inflation described by the curve appeared to break down after the 1960s, and the curve has come under fresh criticism in recent years because of inflation's seemingly odd behavior during and after the financial crisis--it didn't decline as much as some expected as unemployment surged, and it remained strangely stable while the jobless rate came down. Ms. Yellen, in a March speech, cited a paper by Northwestern University economist Robert Gordon defending the Phillips curve's recent performance as well as Dallas Fed research that found a relationship between unemployment and wage growth at the state level once the unemployment rate fell far enough. She previously cited San Francisco Fed research on how downward nominal wage rigidities can affect inflation behavior during and after recessions. The New York Fed on Wednesday published a blog post about how expectations can affect inflation behavior as described by the Phillips curve. The Fed's Washington-based board this summer released a working paper looking at the interplay between monetary policy and inflation expectations. Where's NAIRU? In theory, inflationary pressures build once the unemployment rate falls below a theoretical threshold sometimes called the non-accelerating inflation rate of unemployment, or NAIRU. But there is considerable uncertainty about where to draw that line. Fed policy makers in September offered estimates for the normal long-run unemployment rate ranging from 4.7% to 5.8%, with a median estimate of 4.9%. Two Fed board economists in June released an analysis arguing that a decline in the labor share of national income has been driven by reduced worker bargaining power, which has also pushed down the natural unemployment rate. A Chicago Fed paper in May said that demographic and other forces may be changing the composition of the U.S. labor force in a way that lowers the natural unemployment rate. Missing Link A tighter labor market means firms will bid up wages to attract and retain workers, which in theory should result in higher prices as employers pass along their higher labor costs to customers. But two Fed board economists, in a May paper, said they found it "difficult" to detect the influence of labor costs on price inflation. "In particular, we find evidence either that the passthrough of labor costs to prices has fallen over the past several decades or...that changes in labor costs have had essentially no material effect on price inflation in recent years," they wrote. Write to Ben Leubsdorf at ben.leubsdorf@wsj.com