WASHINGTON (Reuters) – The Federal Reserve’s year-old promise to drive U.S. employment to new heights came at a wrenching moment last August, with 12 million jobs still missing due to the pandemic, inflation cratering to half the central bank’s target, and no clear endgame for the worst health crisis in a century.
Then came three vaccines, a steady jobs recovery, trillions more dollars in fiscal stimulus, the fastest economic growth in 40 years – and surging prices.
A steady shift in Fed rhetoric since inflation jumped in the spring has now triggered debate about how deep the Fed’s new commitment to jobs truly runs, and how long it will tolerate high inflation as it waits for a “broad and inclusive” rebound in employment.
No decisions have been made. The Fed is actively talking about when to reduce its $120 billion per month emergency bond purchases, and Fed Chair Jerome Powell may discuss that in Friday remarks to a virtual iteration of its annual Jackson Hole research conference. The more consequential call over when to raise interest rates from near zero remains, in all likelihood, far down the road.
But with each successive report showing inflation above the Fed’s 2% target, the tone has shifted. Fed officials now readily acknowledge inflation may be more persistent than they thought. Moreover, some are lowering expectations of a full rebound to the pre-pandemic level of jobs or labor force participation.
Inflation, on average
The debate won’t be resolved soon. But the suddenly two-sided nature of the discussion has, to some, cast the value of the Fed’s new approach into doubt.
“I think they have lost their nerve,” said Adam Posen, president of the Peterson Institute for International Economics and a former member of the Bank of England’s Monetary Policy Committee. In recent comments, “they have not reinforced their commitment to broad and inclusive gains” in the labor market.
Richard Clarida, the Fed’s influential chair, would disagree. At a recent presentation to the Peterson Institute, he said his outlook is for inflation above 2% for three years running, for unemployment so low by the end of 2022 that gains would be broadly felt and jobs returned to the pre-pandemic level, and a rate increase in 2023 “entirely consistent” with the Fed’s new approach.
INFLATION VS JOBS
Arguably the last few inflation readings, the latest being almost twice the targeted 2% level, would have been confronted more aggressively by previous Feds.
Some feel a tougher approach may be needed now.
“It is getting a little old to say that this is a transitory increase in prices,” said Vincent Reinhart, chief economist at Mellon, pointing to surveys showing businesses ready and able to pass through price hikes. “If firms say they are worried about prices paid and they have pricing power then…we don’t have price stability. The wheels are greased for costs to pass through.”
Under the new framework, though, the Fed has pledged not to nip job growth in the bud and, to be certain inflation hits the 2% target on average, will allow it to go above that level “moderately…for some time.”
When the new strategy was rolled out, however, it carried an even deeper sort of pledge. Policymakers have long seen tension between unemployment and inflation. If inflation gets too high, the Fed can tame it through rate increases, albeit it at the cost of higher unemployment. When inflation is weak or unemployment high, it can cut rates and trade more jobs for higher prices.
Over 10 years of economic expansion after the 2007-to-2009 recession, that relationship did not hold. As unemployment fell, inflation remained muted, and Fed officials concluded they could exploit that and take more inflation risk to create the type of “hot” economy and robust job market that helps the less well-off.
Inflation and unemployment
Equity is not a goal addressed in the Fed’s congressional mandate, but officials have given the issue more attention as the economic costs of inequality have become better appreciated.
The quandary arose when the pandemic reanimated what the Fed thought it had escaped: conflict between inflation and jobs.
In the thick of the framework debate in 2019 the Fed saw ample jobs and low inflation; now inflation is high, but with 6 million fewer people working than before the pandemic.
That has forced an earlier-than-expected reckoning over issues left unresolved in the new strategy.
What does “moderately” mean when it comes to an inflation overshoot? How fully can the economy recreate the pre-pandemic conditions where, for instance, unemployment hit record lows for African Americans and the share of adults employed or looking for work was climbing steadily?
The “labor force participation rate” hit 63.4% in January 2020. It’s now 61.7%. Black unemployment hit a record low 5.2% in August of 2019, and even then was 1.8 percentage points higher than for whites. As of July it was 8.2%, compared to 4.8% for whites.
AN ‘AMBITIOUS’ GOAL
With inflation gnawing, some Fed officials have begun nipping at what to expect from the jobs recovery.
Clarida, rather than seeing a full rebound of the labor force participation rate, says it can return to an unspecified “demographic trend” dragged lower by the aging population.
Where Powell has talked about the plight of displaced workers, he also notes the number of additional people, perhaps 2 million or more, who retired during the pandemic – thus lengthening the time to get back to the pre-pandemic level of jobs, and increasing the likelihood the Fed may raise interest rates before that happens.
Real Federal Funds Rate
Much depends on inflation. If it proves the product of global supply shocks and reopening, and recedes on its own, the potential tradeoff with the job market eases.
If not, then the Fed’s priorities will be tested in ways not envisioned when the new strategy was approved.
“They set a very ambitious goal. This is year one…We don’t know if it’s successful for at least a couple of years,” said Edward Al-Hussainy, senior rates and currency analyst for Columbia Threadneedle Investments. “The first priority is still the recovery in the labor market…People are starting to lose focus on that.”
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