The first two articles in this issue of The Real Economy explore the Federal Reserve's dilemma of taming inflation while maintaining full employment. They are from a series examining the overriding monetary and fiscal policy challenges in today's economy. Read part 1 here:
Despite recent gains in the labor market and rising inflation, we think the Federal Reserve will act in measured steps as it removes its financial accommodation. Monetary policy will continue to adapt to a new set of circumstances within the labor market and regarding to the potential growth of the economy.
As we look ahead to the eventual transition of the pandemic into a more manageable endemic—once the omicron variant eases—we are looking for a gradual acceleration of the Fed’s policy normalization beginning no later than the second quarter. There is the caveat of delayed action should new outbreaks emerge.
As for fiscal policy, Congress seems unlikely to pass the second half of the Biden administration’s infrastructure revitalization program. After allocating money for rebuilding the nation’s failing transportation and energy systems, this half of the administration’s program was focused on boosting the productivity of the labor force and the transition to an economy centered on innovation.
These decisions, by the Fed and Congress, will affect the climate for investment. Low interest rates will continue to add to the profitability of private capital investment with debt paid off in deflated dollars.
And government investment in infrastructure and the productivity of the labor force would facilitate the global competitiveness of those businesses and will form the foundation for higher wages and wealth accumulation of the U.S. labor force.
With fiscal investment either already allocated or at the mercy of political pressures, our discussion that follows centers on monetary policy and the Fed’s dual mandate for full employment and price stability.
This is of increasing importance as the pandemic continues to have a profound impact on the labor market, global supply chains and inflation.
What constitutes full employment?
As workers have returned to the labor force, incomes have risen and the unemployment rate has dropped to 3.9%, a robust discussion has followed over what constitutes full employment in the American economy.
For the Fed, it’s more than an academic debate. Congress, after all, has given the Fed a dual mandate of maintaining price stability and achieving full employment.
The Fed defines full employment as having a 4% unemployment rate. That’s down from the 5% of previous decades and reflects a shifting economic landscape. Broad demographic changes, a quicker pace of innovation and restrictions on immigration have all expanded what constitutes full employment.
In our estimation, the definition of full employment is closer to a 3.5% unemployment rate or lower.
But at the same time, achieving this mandate can lead to pressures from the other half of the mandate.
Now with inflation having accelerated to the highest level in decades, policymakers face a dilemma: The Fed must achieve full employment while taming price increases. That means moving its policy variable on inflation—the core personal consumption expenditures index—back to 2% from the current 4.7%.
Indeed, that process is about to begin. We are looking for a gradual acceleration of the Fed’s policy normalization beginning no later than the second quarter with the market anticipating three to four hikes in the federal funds rate this year, all of which could change if the omicron variant inflicts more damage to the economy.
In the end, the American workforce was dealt a significant setback during the pandemic and has yet to fully recover. Even as the unemployment rate nears what the Fed considers full employment—we see it ending the year closer to 3.5%—that goal has yet to be achieved and will require a careful balancing act by central bankers.
Redefining the dual mandate
In a standard Taylor Rule model of central bank behavior, the Fed responds to an overheating economy by increasing interest rates to counter a tightening labor market in which wage pressures further add to rising prices.
Current estimates of the equilibrium conditions in the labor market now center on an unemployment rate of 4%. That is, at any one time, 4% of the labor force participants are expected to move from one position to another within a growing economy capable of offering employment choices for workers.
Stability of prices is defined as long-term average price increases of 2% per year, with the 2% inflation target thought to be consistent with sustainable economic growth and sufficient consumer demand to bid up prices.
When inflation is averaging lower than 2%, that is a sign of insufficient demand and economic stagnation, as was most recently the case during the decadelong recovery from the Great Recession.
All of this must be balanced with the demographic and societal changes that seemingly exploded across the economy during the two years of the pandemic. The Fed was not caught unaware and had already adopted policies to address these overriding issues.
The mandate for full employment
The tightness of the labor market is measured by the gap between the current rate of unemployment relative to its equilibrium level. If the unemployment rate is consistently lower than the equilibrium rate, that indicates the potential for rising wages as employers compete for a smaller pool of labor and an overheating economy. Under those conditions, the Fed usually raises interest rates.
But if the unemployment rate is consistently higher than its equilibrium rate, that indicates an underperforming economy, and the Fed seeks to facilitate investment and spending by pressuring interest rates lower.
Over the past 20 years, the equilibrium unemployment rate had been assumed to be about 5% in general terms. That is, in normal times, about 5% of the labor market is transitioning from one job to another as businesses close or as employees exercise their choice in employment.
Recall that labor market churn is a sign that employees are able and willing to advance themselves, growing the economy. The last time the unemployment rate dipped below 4%, during the economic boom of the dot.com years and then again in 2019, the consensus was that the equilibrium rate had briefly dipped to 4.5% in the late 1990s and 4% before the pandemic.
Formal estimates by the Congressional Budget Office of the noncyclical rate of unemployment—the rate of unemployment caused by all factors other than the business cycle—peaked at 6% in 1979, dropping to 4.5% in the third quarter of last year. Expectations are for that slow decline to continue over the next decade.
So if the unemployment rate has broached its equilibrium level—and prices are rising—why have the central banks in the United States, Canada and the U.K. balked at raising their policy rates off the zero bound?
Given the changing demographics of the labor force and the diminished reward for working in traditional occupations, we have reason to think the Federal Reserve is looking past the traditional U3 rate of unemployment, which as we’ll show applies only to a segment of the population.
Given the significant changes in an evolving labor market, we’d argue that the target for the equilibrium level of unemployment should be 3.5% or lower.
Here are some factors that suggest that an accommodative monetary policy stance—coupled with investment by the fiscal authorities in the labor force—is required until the supply of labor is replenished and until all segments of society are rewarded for their labor.