The BLS announced Friday that the US economy added 295,000 jobs in February, bringing the unemployment rate to 5.5 percent, a new low for the recovery. The leading stock indexes immediately plunged. The Dow lost 1.5 percent, the S&P 500 1.4 percent, and the NASDAQ 1.1 percent. Why the negative reaction to such good news?
The answer may lie in an obscure economic indicator known as the non-accelerating inflation rate of unemployment, or NAIRU. The NAIRU gets its name from the fact that when unemployment hits that level, the rate of inflation begins to accelerate. Market participants know that the Fed has a dual mandate to maintain full employment and price stability, and some of them interpret that to mean that it will begin to raise interest rates as soon as the unemployment rate hits the NAIRU.
As the following chart shows, that could happen any time now. The Congressional Budget Office estimates that the NAIRU is currently 5.39 percent, within easy reach of February's current unemployment rate of 5.5 percent.
There is just one problem with this scenario. NAIRU or no, the rate of inflation shows absolutely no sign of accelerating, or even of slowing its rate of decrease. The Fed's favored measure of inflation is the personal consumption expenditure index (PCE), an indicator derived from the GDP accounts. In Q4 2014, the inflation reading for the PCE was just 1 percent, compared with the same quarter a year earlier. That was not all due to falling gasoline prices, either. Year-on-year inflation for the core PCE, which excludes food and energy, was just 30 basis points higher (1.04 percent vs. 1.01 percent).
We don't know the PCE deflator for Q1 2015 yet, but judging from the consumer price index, which went negative last month, it is highly likely that PCE inflation will turn out to be still lower when the data become available at the end of April. Supposedly, the Fed is targeting 5.5 percent unemployment and 2 percent inflation. With inflation still headed down as unemployment approaches the NAIRU, it looks like we are headed for a bad miss on the low side, as the next chart shows.
What, then, is the source of the fear that falling unemployment is about to cause the Fed to hit the brakes to stop an inflation breakout? Perhaps it comes from a conviction that the Federal Open Market Committee has a silent majority who have been lying low, but are suddenly going to start voting for higher interest rates once unemployment hits the NAIRU.
Perhaps it comes from a belief that official inflation numbers are being manipulated in some Argentine-style conspiracy, but that price increases will soon break out in the open in a way that forces everyone (including the FOMC majority) to see the truth. Or perhaps it comes from the belief that the NAIRU is not just a benchmark, but rather, a tipping point beyond which inflation turns a right angle and starts heading for the sky.
Personally, though, if I wanted to bet my retirement savings on the direction of inflation over the coming months, I would bet against the inflationistas. There is more slack left in the labor market than meets the eye. Let's wait at least a few months yet before we hit the panic button.