By Howard Schneider

WASHINGTON (Reuters) – The last time the U.S. unemployment rate fell below 3%, as one Federal Reserve official has predicted it will this year, the Korean War was nearing its end and a recession that saw legions of workers lose their jobs was just around the corner.

While the circumstances were unusual, it nonetheless presented a now-familiar pattern – a falling unemployment rate eventually giving way to recession – that current Fed officials will be challenged to avoid as they try to slow the fast pace of inflation without wrecking an expansion that is delivering strong gains for workers.

Emblematic of the current confidence in the job market’s strength, St. Louis Fed President James Bullard last week said he expects the U.S. unemployment rate to fall below 3% this year. That flashback to the 1950s in itself would be a warning for some economists.

Such a low unemployment rate is “a red flare” that the economy is overheating, with fast price and wage increases that are unavoidable and the U.S. central bank pushed to be more aggressive, said Tim Duy, a University of Oregon professor and the chief economist of SGH Macroadvisers. “I don’t see where there is a good way out” that tames inflation without triggering a recession and the associated jump in unemployment.

It’s a tradeoff – of jobs for price control – the Fed thought had become less relevant. In the decade before the onset of the coronavirus pandemic, unemployment drifted towards 3% without triggering inflation, and policymakers felt that showed the economy could put far more people to work than previously thought with prices remaining stable.

‘HARD LANDING’ AHEAD?

The pandemic has rekindled that debate and raised doubts about whether inflation, the work choices of Americans, even the global economy overall, will follow the patterns that existed before two years of mass infection, fear and lockdowns.

In 2019, for example, the unemployment rate hovered around 3.5% while inflation struggled to hit the Fed’s 2% target. Going into 2022, amid a global tangle of supply-chain bottlenecks, workers’ reluctance to take jobs, and the ongoing pandemic, the unemployment rate was about 4%, businesses wanted far more workers than were willing to take a job, and inflation was nearly triple the Fed’s objective.

U.S. central bank officials still think they can avoid a recessionary “hard landing” as they begin what Fed Chair Jerome Powell says will be a steady removal of the low interest rates and other measures meant to help the economy through the pandemic. Policymakers at this point support that approach, with the first rate hike widely expected to come next month.

Yet despite their seeming agreement, a subtle divide exists between those who feel much of the current inflation remains tied to the pandemic and will likely ease on its own and those who feel the Fed itself will have to do the bulk of the work on inflation, lifting interest rates enough to slow the economy.

In the simplest case that difference is a matter of timing, and could resolve itself in a few months if inflation moves clearly in one direction or the other, and pulls policymakers’ opinions along with it. But more fundamentally it’s about how the economy may have changed since March 2020, a debate that will shape how upcoming economic data gets interpreted, how fast monetary policy may veer in one direction or the other, and whether the pace of inflation can be tamed without a downturn.

POTENTIAL FOR MISTAKES

Bullard, for one, said in a Reuters interview that it was “premature” for anyone to argue the Fed was behind in its inflation fight. Indeed, he said the central bank was well-poised to do what was needed.

But he also said he felt monetary policy, by limiting demand through higher interest rates and controlling expectations about inflation, would be responsible for “a significant portion” of the inflation fight. He was “pessimistic” that improvements in global supply chains, the return of individuals to the job market, or other improvements would offer any imminent help and allow the Fed to proceed less aggressively.

“I am not deaf to the supply-side arguments,” he said. Yet while policymakers are aligned on the initial rate increases, “there will be a moment at some point in the future where it will be a tougher decision … How much do you want to tighten policy and how much are you risking recession?”

Minneapolis Fed President Neel Kashkari by contrast has said rates may only need to rise “a little bit,” more like easing off the accelerator of an automobile than tapping its brakes.

Mistakes, and recession risks, can come from either direction – doing too little and allowing inflation to take deeper root; doing too much and causing an unnecessary downturn.

UNPREDICTABLE DATA

The Labor Department’s jobs report for January, which was released earlier on Friday, showed what the Fed is grappling with in an era when neither prices or employment – the two pillars of its policy mandate – are behaving as expected.

Many analysts forecast that the economy had actually lost jobs last month amid a record surge in COVID-19 cases and as businesses scaled back either out of caution or because their employees were sick.

The report, however, showed employers added 467,000 jobs, and wages jumped, a sign of the pressures building in the economy despite the jump in infections driven by the Omicron variant of the virus.

A surprise to the other side: Labor force participation rose and the unemployment rate actually edged up a tenth of a percentage point, a trend that if established could work in favor of a less aggressive Fed.

But as it stands “we have to take the numbers at face value, and they paint a picture of a labor market on fire,” wrote Jefferies economists Aneta Markowska and Thomas Simons, with the Fed likely heading towards “a more sustained tightening cycle and a higher terminal rate.”

(Reporting by Howard Schneider; Editing by Dan Burns and Paul Simao)

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