Trump's dilemma: slower job growth or rising rates and inflation?

By Howard Schneider

WASHINGTON (Reuters) - A drop in the U.S. unemployment rate last month to a 9-year low signals the risk of a collision between President-elect Donald Trump's plans to goose the economy and the Federal Reserve's efforts to tap the brakes with higher interest rates.

Since Trump's election, officials at the U.S. central bank have cautiously introduced the possibility that his spending and tax cut plans could prompt a faster pace of rate increases than the two hikes currently foreseen in 2017.

An increase is already expected when the Fed meets in two weeks. Fresh economic projections, the first since the election, will also be issued and Fed Chair Janet Yellen will hold a news conference when the meeting concludes on Dec. 14.

With November's decline, the jobless rate is now already below the most optimistic projections from Fed policymakers for where it would stand at year end.

If it keeps moving lower, Trump's spending and tax cut plans may be adding fuel to a tank that's already brimming. Possible new trade or immigration restrictions could make markets even tighter, and switch the Fed from worrying about the risk of deflation to fighting price rises before they get out of hand.

"There is much more than the Trump election driving the ... rally that started the day after the election," Bank of the West chief economist Scott Anderson wrote. "We are seeing signs of a synchronized rebound in the global economy."

When Fed policymakers issued their last projections in September, the lowest level predicted for the unemployment rate at the end of the year was 4.7 percent. In November, it fell three-tenths of a percentage point to 4.6 percent.

The decline was partly due to a drop in the labor force participation rate, which officials have expected to begin falling again because of an aging population with more retirees. In general, the lower the unemployment rate, the slower the pace of job growth the economy can sustain without pushing up wages and prices too quickly.

Policymakers insist they still have time to move rates higher to keep price increases under control. Several officials feel it may even help fix some of the damage from the 2007-2009 recession if inflation moved above the Fed's 2 percent target for a while. That might, for example, allow steady wage increases to restore some of the ground lost by workers.

However, in recent months even ostensibly dovish officials, like Boston Fed President Eric Rosengren, have cautioned that steady rate hikes might be needed to avoid the need for even faster increases that could trigger a recession.

"I view a small step up in interest rates as appropriate, not because I want to curtail the expansion, but because I believe it will help prolong the expansion," Cleveland Federal Reserve Bank President Loretta Mester said on Wednesday..

Trump's victory gives that debate more urgency. His plans for a big infrastructure spending package, tax cuts and tighter controls on immigration could test the limits of what the economy can absorb before overheating.

For a year now, Fed officials have said they expect job growth to slow as the economy nears full employment. It hasn't happened, meaning Trump will take office at what may be a tough point of inflection: either job creation slows or inflation jumps.

Jed Kolko, chief economist at the Indeed job site, said the current pace of job growth and low unemployment rate "sets a baseline for the Trump administration."

"Recent wage gains and unemployment declines make this a tough economy to improve on," he said.

(Reporting by Howard Schneider; Editing by Tim Ahmann and Andrea Ricci)

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