by Calculated Risk on 4/16/2014 12:20:00 PM

From Fed Chair Janet Yellen: Monetary Policy and the Economic Recovery. Excerpts:

Is there still significant slack in the labor market?
...
I will refer to the shortfall in employment relative to its mandate-consistent level as labor market slack, and there are a number of different indicators of this slack. Probably the best single indicator is the unemployment rate. At 6.7 percent, it is now slightly more than 1 percentage point above the 5.2 to 5.6 percent central tendency of the Committee's projections for the longer-run normal unemployment rate. This shortfall remains significant, and in our baseline outlook, it will take more than two years to close.

Other data suggest that there may be more slack in labor markets than indicated by the unemployment rate. For example, the share of the workforce that is working part time but would prefer to work full time remains quite high by historical standards. Similarly, while the share of workers in the labor force who are unemployed and have been looking for work for more than six months has fallen from its peak in 2010, it remains as high as any time prior to the Great Recession. ...

The low level of labor force participation may also signal additional slack that is not reflected in the headline unemployment rate. Participation would be expected to fall because of the aging of the population, but the decline steepened in the recovery. Although economists differ over what share of those currently outside the labor market might join or rejoin the labor force in a stronger economy, my own view is that some portion of the decline in participation likely represents labor market slack.

Lastly, economists also look to wage pressures to signal a tightening labor market. At present, wage gains continue to proceed at a historically slow pace in this recovery, with few signs of a broad-based acceleration.

Is inflation moving back toward 2 percent?
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I will mention two considerations that will be important in assessing whether inflation is likely to move back to 2 percent as the economy recovers. First, we anticipate that, as labor market slack diminishes, it will exert less of a drag on inflation. However, during the recovery, very high levels of slack have seemingly not generated strong downward pressure on inflation. We must therefore watch carefully to see whether diminishing slack is helping return inflation to our objective.10 Second, our baseline projection rests on the view that inflation expectations will remain well anchored near 2 percent and provide a natural pull back to that level. But the strength of that pull in the unprecedented conditions we continue to face is something we must continue to assess.

Finally, the FOMC is well aware that inflation could also threaten to rise substantially above 2 percent. At present, I rate the chances of this happening as significantly below the chances of inflation persisting below 2 percent, but we must always be prepared to respond to such unexpected outcomes, which leads us to my third question.

What factors may push the recovery off track?

Myriad factors continuously buffet the economy, so the Committee must always be asking, "What factors may be pushing the recovery off track?" For example, over the nearly 5 years of the recovery, the economy has been affected by greater-than-expected fiscal drag in the United States and by spillovers from the sovereign debt and banking problems of some euro-area countries. Further, our baseline outlook has changed as we have learned about the degree of structural damage to the economy wrought by the crisis and the subsequent pace of healing.

Currently Yellen sees substantial slack in the labor market, and is more concerned about low inflation than high inflation. This suggests rate will be low for a long time.