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Analysis : Falling Unemployment Could Pressure Fed to Move Faster on Rates -- Update

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05/04/2018 | 12:04pm EDT

By Nick Timiraos

Friday's jobs report illustrates the challenge the Federal Reserve faces this year as the economy enters a more delicate phase for setting interest-rate policy. It also shows why officials are split over whether to raise rates three or four times this year after raising them three times last year.

For the last several years, markets have watched monthly employment reports for signs that job gains would permit the Fed to gently raise interest rates.

Now, after several rate increases and with unemployment at an 18-year low, the question is whether joblessness might fall so much that Fed officials should pick up the pace of tightening to prevent the economy from overheating.

The latest employment report released Friday by the Labor Department puts a point on that question. The unemployment rate dropped to 3.9% in April after holding at 4.1% for the prior six months, and employers added 164,000 jobs. The last time unemployment stood at a lower level was April 2000.

A broader gauge of underemployment fell to 7.8%, its lowest level since 2001.

Average hourly earnings of private-sector workers rose 2.6% from a year ago, in line with recent monthly readings. A separate index of wages and salaries of private-sector workers released last week by the Labor Department showed they rose 2.9% for the year ended in March, which was the strongest gain in nearly a decade.

Last year, officials were less worried about unemployment potentially slipping below the rate they consider sustainable over the long run, currently estimated at around 4.5%, because inflation also softened surprisingly, running below the central bank's 2% target.

Now they may be more attuned to rising wages and declining unemployment because inflation is much closer to their target. Consumer prices, excluding food and energy items, rose 1.9% for the year ended March, according to the central bank's preferred gauge, up from 1.6% in February.

Most Fed officials haven't shied away from their fundamental view, embodied by the so-called Phillips curve, that tighter labor markets will drive stronger wage growth and more inflation. Some are worried that this relationship could be nonlinear, meaning inflation pressures grow even stronger after labor markets tighten beyond a certain point.

Others say skepticism is warranted. The natural rate of unemployment could be lower than officials have expected. Even if some type of relationship between unemployment and prices exists, it could take longer for resource pressures to push up prices.

So far, strong hiring and stable growth has translated into steady -- but not outsize -- gains in wages. This reflects weak productivity growth and possibly a greater level of slack in the labor market than many economists initially believed.

All of this is playing out in a moment when Washington has approved new tax cuts, which economists expect to boost U.S. growth over the coming two years. Wall Street forecasters see unemployment falling to 3.5% by year's end. Fed officials see unemployment falling to 3.8% this year.

Fed officials want a tight labor market to push inflation up to 2%, which they see as a healthy level for an expanding economy, but don't want price pressures to surge out of control. Some worry if the economy gains too much momentum, they would have to raise rates more aggressively, which could derail the recovery.

Officials will have one more employment report, on June 1, before their June 12-13 policy meeting to draw any firm conclusions. A rate increase is widely expected at that meeting.

Market expectations of Fed rate increases this year are right where officials want them to be. Policy makers were nearly split in March over whether to raise rates three or four times this year, and futures contracts on Friday morning implied a nearly 40% probability of four rate increases this year, according to CME Group.

"Thus far, the Fed has been sitting on the fence contemplating whether it is going to do three rate hikes or four," said Kristina Hooper, chief global market strategist at Invesco. She predicted Friday's report would move them toward penciling in four rate increases. "The totality of the data they're seeing will push them...in that direction," she said.

Fed officials surely cheer signs the tight labor market is drawing people back to work. The share of adults aged 25 to 54 who are working held at 79.2% in April, near the highest level since July 2008, when the economy was contracting sharply. That is up from a recent low of 74.8% in November 2010, but still below the 80.1% high point reached during the mid-2000s expansion.

While the Fed is likely to welcome a pickup in wage growth, such an upturn also would signal that the central bank is entering a delicate policy stage. If officials raise rates too slowly, the economy could overheat. If they move too aggressively, they could trigger a recession.

Inflation is at the Fed's 2% target, and productivity, or output per labor hour, rose 1.3% in the first quarter from a year earlier, implying wages should be able to rise as much as 3.3% a year before pushing inflation higher.

Write to Nick Timiraos at nick.timiraos@wsj.com

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