Why Fed may hike rates before seeing uptick in inflation

Further falls in America's jobless rate will lead inflationto start rising early next year, according to a forecast based on researchFederal Reserve Chair Janet Yellen has cited as shaping her confidence a ratehike could be needed this year.

Yellen has recently faced a rebellion at the central bank,with two Fed governors arguing that rate hikes should be delayed because of abreakdown in the tendency of low unemployment to fuel faster inflation, arelationship called the Phillips curve.

Governor Lael Brainard said this month that the Phillipscurve relationship was "at best, very weak at the moment" whileDaniel Tarullo said it has not been "operating effectively for 10 yearsnow."

With the Fed's rate-setting committee meeting on Tuesday andWednesday, Yellen and Vice Chair Stanley Fischer may seek to show the bankshould not wait for inflation to appear before hiking rates. Both Yellen andFischer have backed the relationship between jobs and inflation.

"The Phillips curve is alive and well," saidRobert Gordon, an academic at Northwestern University whose 2013 paper on thesubject was cited by Yellen and Fischer in speeches this year.

Gordon said the key reading to watch for signs of inflationwas the short-term unemployment rate, those out of work less than six months,rather than the overall jobless rate. The relationship between that short-termjoblessness and prices has held for 50 years, he said.

The short-term rate appears to matter because businesses setwages based on plausible candidates for a job, so the surge in people out ofwork for long spells since the recession might not influence inflation.

The short-term jobless rate has sunk to 3.7 percent, whichis lower than it was at the outset of the 2007-09 recession. The overallunemployment rate is currently 5.1 percent.

Gordon's projection is that the short-term rate will sink to3.5 percent by the end of 2016 and 3.3 percent by early 2017.

Inflation excluding food and energy, currently at 1.3percent, would start slowly in the first quarter of 2016, with overall inflationrising from its current 0.3 percent rate to the Fed's 2 percent target by 2020,Gordon said.

Many Fed policymakers actually expect inflation will risemore quickly, so Gordon's projections are not an argument for the Fed to moreaggressively head off price increases.

They do, however, shed light on why the Yellen and others atthe Fed are confident inflation will rise.

"Considerable historical evidence suggests thatinflation will eventually begin to rise as resource utilization continues totighten," Yellen said in a March speech in which she cited Gordon's paperas supporting her belief in the Phillips curve.

Fischer cited Gordon's paper in August at the Fed's JacksonHole conference, arguing the labor market played "at least some ongoingrole" in determining inflation even though import prices can maskinflationary pressure created by employment.

Gordon's projections do not consider the chance a globaleconomic slowdown could increase joblessness and stop inflation dead in itstracks, or that a decline in imported oil prices could keep inflation low.

But inflation could be expected to accelerate whenever theshort-term rate was below 3.9 percent, which Gordon estimated would correspondto a total unemployment rate of 5.3 percent.