As the economy improves, understanding when the long-term unemployed will return to the workforce has become, particularly in the last few months, the central issue among economists as to when the Federal Reserve should begin looking at raising interest rates in anticipation of higher inflation.

But the problem is that economists are in deep disagreement as to when, or even if, the long-term unemployed will have a material impact on putting pressure on wages, which bolsters our thesis that America’s central bankers will again likely fail to time rates correctly.

Fed Chair Janet Yellen’s position is that wage gains continue to proceed at a historically slow pace in this recovery, with few signs of a broad-based acceleration, though she does expect the long-term unemployed to eventually rejoin the workforce.

In late April, in her first major monetary-policy framework speech to the Economic Club of New York, she said, “The long-term unemployed are likely to move back more actively into the labor force and into the job market and exert pressure on wages and prices. Clearly, we will have to watch unfolding evidence and evaluate it with an open mind.”

But even with the jobless rate near a five-year low, more than 3.7 million Americans have been unemployed six months or longer. Their share of the total ranks of the jobless exceeded 30 percent for the first time in 2009 and hasn’t fallen below that level since. That gauge stood at 35.8 percent in March, down from a record 45.3 percent in April 2010, according to Bloomberg estimates.

As such, some economists disagree with Yellen’s position that the long-term unemployed should continue to be factored into inflation projections or that they will help hold down inflation pressures or provide slack. As such, they believe the short-term unemployed should be the focus of the central bank’s inflation targets and analysis, noting that the rate of 4.3 percent is now more or less back to its long run average – and thus argues for a less accommodative stance.  

In a paper for the Brookings Institution, former White House chief economist Alan Krueger looked at data on the long-term unemployed from 2008 to 2013 and documented the incidence of repeat joblessness. About 36 percent of those workers were in a job 15 months later, according to his analysis. But only 11 percent were in steady, full-time jobs. ​​

Krueger, in his paper, argues that the long-term unemployed are on the margins of the labor force, both because they give up on searching for a job and because employers start to discriminate against the long-term unemployed.  “We tentatively conclude that the long-term unemployed exert relatively little pressure on the economy,” he said, in a Financial Times interview. As a result, the economist concludes that long-term unemployment does little to hold down wages, and, as noted, with short-term unemployment back to normal, rates should start to rise in anticipation of increased inflation.

Notwithstanding this, many argue that most measures of U.S. wage inflation are sluggish at best. In response to this argument, Yellen has said that it is premature to jump to this conclusion. She has offered that the Fed would be alert to “wage pressures that can translate into price pressures and be an early warning indicator of an impending uptick in inflation.”

But even as these economists make compelling arguments, both sides suffer from one main weakness, which is that the United States has never throughout its history had a similar period where its population suffered comparable periods of long-term joblessness. Thus, there is no baseline of comparison.

Producer Prices, Inflation Expectations on the Rise

Even as economists debate whether wage pressure is being exerted on the economy, investors have continued to react to recent inflationary signals, such as the rise in producer prices, with increased buying of inflation protection securities (See Chart A).

Chart A: Investors Continue to Buy Up Inflation-Protection Securities

As noted in a previous report, the prices businesses receive for their goods and services rose in March, defying a long stretch of subdued inflation across the U.S. economy, according to the Wall Street Journal. The producer price index for final demand, which measures changes in prices for everything from food and machinery to warehousing and transportation services, rose a seasonally adjusted 0.5% from February, the Labor Department reported on April 11. The index rose 0.6%, excluding the volatile categories of food and energy.

Economists surveyed by the Wall Street Journal had expected the index to rise a more modest 0.1%, and predicted a 0.2% increase excluding food and energy. The index fell 0.1% in February, unchanged from the Labor Department’s initial estimate. The PPI for final demand was up 1.4% in March from a year earlier, the biggest year-over-year increase since last August.

The PPI measures the prices businesses receive from buyers such as governments, consumers and other businesses. The Labor Department overhauled the report this year to measure a much broader swath of the U.S. economy.

Given increasing expectations for inflation over the next few years are increasing as measured by demand for inflation protection securities, we recommend investors hold new portfolio holding iShares Barclay TIPS Bond (TIP), which we added to our Survive Portfolio in early March to enhance our fixed income offerings. TIP which is up 3.45% since the beginning of the year is a buy up to 118.