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This is why the Fed should start worrying about inflation again

Is Janet Yellen concerned enough about inflation? (Jacquelyn Martin/ Associated Press)

The hawks are having a rough time at the Federal Reserve.

These are the officials who believe that guarding against inflation is the central bank’s overriding mission. They are a vocal minority within a dovish Fed, where the primary goal since the recession has been fighting unemployment. The hawks have been pilloried since the release of transcripts of meetings in 2008 showed how preoccupied they were with a temporary uptick in prices as the global financial system unraveled around them. Their argument that the Fed’s stimulus is sowing the seeds of future inflation has fallen flat after five years of easy money. If anything, global leaders are warning against the perils of deflation.

But the hawks could still be proven right. On Friday, the government is slated to release its monthly report on the health of the labor market. There’s a strong possibility that it will show the unemployment rate has hit the 6.5 percent threshold the Fed has set for considering raising interest rates. As it turns out, that threshold is also an important marker for the behavior of inflation.

Let’s back up for a second. The reason the Fed set its unemployment threshold at 6.5 percent was that officials generally felt a jobless rate above that level was a sign that the economy was still in distress. Over the past 30 years, high unemployment was also typically accompanied by falling prices. Both are signs that the Fed should keep interest rates low.

But a funny thing happens once unemployment hits 6.5 percent: The behavior of inflation starts to become random, as illustrated in this chart by HSBC chief U.S. economist Kevin Logan.

The black line represents the average annual unemployment rate for the past 30 years. You can see that in all but two cases (both of which were temporary shocks), inflation declined when the jobless rate was above 6.5 percent. But when unemployment rate fell below that point, inflation was almost as likely to increase as it was to decrease. In other words, what happens to inflation below the Fed’s threshold is anybody’s guess.

Of course, history may not be the best road map as the Great Recession and Turgid Recovery (I just coined that) have defied conventional economic models. Inflation seems unlikely to spike in the short term as factors such as long-term unemployment and labor underutilization skew the jobless numbers.

But the question of how far the Fed can push the economy becomes more urgent below the 6.5 percent threshold. Eventually, inflation will start to rise -- maybe even rapidly.

The challenge is pinpointing when. Minneapolis Fed President Narayana Kocherlakota has advocated waiting at least until the unemployment rates falls to 5.5 percent to raise rates. An influential paper by veteran Fed economists Chris Erceg and Andrew Levin suggested that the central bank should overshoot its estimate of full employment for a while to bring discouraged workers back into the labor force.

But San Francisco Fed President John Williams -- who has been one of the biggest supporters of easy money -- recently warned of the dangers of overshooting. In an interview with the Financial Times this week, he said that he would favor raising rates when unemployment hits 6 percent, well before the labor market is fully healed.

That suggests that hawks could discover some surprising new allies as the Fed’s line in the sand is washed away.