FED FOCUS-Possible wage deflation a cloud over recovery

CHICAGO, July 20 (Reuters) - Federal Reserve officials have sounded more upbeat about the economy lately but the weak labor market, and a specter of wage deflation, looms over the recovery that many expect to start in the current quarter.

A jobless recovery and falling wages could rekindle the kind of negativity that raged for much of 2008 and has only abated in the past few months. At the least, falling real wages make a consumer-led recovery more elusive.

Policy-makers maintain that stimulus from the bank's aggressive monetary policies and the huge fiscal stimulus package is working on a lagged basis, and is close to pushing the economy over the tipping point.

But the final outcome may still hang in the balance without a strong catalyst for growth from consumer spending.

The upshot is that the Fed's benchmark lending rate could be held at the ultra low zero to 0.25 percent range beyond the middle of 2010 -- despite market forecasts for the Fed to start tightening early next year.

"We have already seen a noticeable slowdown in wage growth and reports of wage cuts have become increasingly prevalent," San Francisco Fed President Janet Yellen said in a recent speech.

"With unemployment already substantial and likely to rise further, the downward pressure on wages and prices should continue and could intensify," Yellen said.

Wages and salaries account for just over half of all U.S. personal income.

Falling wages "would make it harder for U.S. households to increase their personal saving rate without putting yet more downward pressure on spending growth," Jan Hatzius, economist at Goldman Sachs, said in a note to clients.

In a worst-case scenario, Fed officials may fear that if consumer spending peters out, the positive inventory cycle that is expected to lead the nation out of recession is at risk of reversing as well.

JOB LOSSES CONTINUE

The Federal Open Market Committee bumped up its central tendency forecasts for 2009 and 2010 growth at its June policy meeting, and any private forecasters expect growth to resume in the current quarter.

Real GDP for 2009 was forecast at minus 1.5 to minus 1 percent, against an April forecast of minus 2 to minus 1.3. For 2010, the FOMC forecast growth of 2.1 to 3.3 percent, up from 2 to 3 percent forecast previously.

The Blue Chip Economic Indicators Survey sees third-quarter growth of 1 percent, after a contraction of 1.8 percent in the second quarter.

But rising GDP, by itself, will not create positive vibes for the thousands of Americans still losing their jobs: 1.3 million in the past three months alone.

On Monday, Atlanta Fed President Dennis Lockhart noted "mostly negative" news recently about consumer spending, as well the recent downturn in consumer confidence.

"Expectations of future economic conditions, and particularly employment prospects, are weighing on attitudes," Lockhart said at a speech in Nashville, Tennessee.

The U.S. jobless rate hit 9.5 percent in June, the highest in almost 26 years, but on other measures the labor situation is even weaker.

The San Francisco Fed's measure of joblessness plus involuntary part-time work is expected to peak at about 16 percent, worse than levels hit in the severe 1982 recession.

U.S. average hourly earnings in June were flat compared with May, and over the past three months rose only 0.7 percent, the smallest gain in the history of the series.

"The annual growth rate of earnings dropped to 2.7 percent from 3 percent, and there is a good chance that it will turn negative at some point over the next year," said Paul Ashworth senior U.S. economist at Capital Economics in Toronto.

CHRONIC UNEMPLOYMENT

On Monday, the National Association of Business Economics poll forecast continued weakness in labor markets.

Eighteen percent of respondents in NABE's July survey reported that wages and salaries fell over the past three months, versus only 10 percent that flagged an increase.

The "net rising index" of minus 8 was a record low in the survey, which dates back to 1982. Only six percent said employment was increasing at their firm, also the lowest in the history of the survey.

A rule of thumb often invoked is that workers face lower starting salaries in a new job, compared with their previous salary, the longer they are unemployed.

The current recession has been marked by high rates of chronic joblessness as well as the likely permanent demise of many higher-paying manufacturing jobs.

"The economy is changing, and some of that employment is not coming back. So these people are going to be structurally unemployed. We're going to have to retrain and that retraining takes time," said Paul Kasriel, director of economic research at Northern Trust in Chicago.