A reporter called last week seeking views on labor market conditions, labor slack, and the Fed’s view on labor markets generally, given Chair Yellen’s recent congressional testimony. Here is how the conversation went.
Despite the marked improvement in the headline unemployment rate, a deeper look at labor markets makes it clear that many problems still exist. The official labor force has declined, which partially explains the improvement in the headline unemployment rate, but unemployment among important labor market segments like young men and women and minorities is still high. The number of people who have been unemployed six months or more combined with those working part-time but wanting to work full-time is still much higher than in normal times. Job growth is fragmented, with most of the gains coming in low-skill, low-wage jobs. At the same time, there is a growing scarcity of highly skilled labor, hence the debate over whether the skill mismatches signify structural rather than just cyclical problems. To some, the drop in the participation rate is also a problem, although no one knows what the equilibrium participation rate should be. Finally, wage gains appear to have lagged growth in the economy. In short, those who emphasize slack in the labor market in policy discussions have plenty of arguments to work with.
The FOMC’s focus on labor markets and unemployment is rooted in two somewhat separable concerns. The first is the employment objective included in the Fed’s so-called dual mandate established by Congress. It is contained in Section 12 U.S.C. § 225a of the United States Code, which states: “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy's long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” While this charge focuses on monetary and credit growth, the Fed’s policy instrument, at least until the financial crisis, used the short-term federal funds rate to influence monetary aggregates, credit growth, and the term structure of interest rates in order to foster economic growth to stimulate employment while keeping inflation low.
The mandate seems precise, but there is substantial room for interpretation. For example, while some might view the term stable prices to mean that the price level should be held constant, or nearly so, the Fed has interpreted it most recently to mean that it should target a 2% inflation rate as measured by the Personal Consumption Expenditures Price Index. Note that, even at 2%, the price level would double every 22 years or so, which is hardly what one could view as stable. Even more vague is the term maximum employment. The term has been interpreted to mean “full employment,” consistent with an economy growing at its potential and with low inflation. But we don’t know exactly how to identify a specific numerical target to define full employment. Economists have tended to focus on numerical targets for unemployment – 5%, for instance – based on the idea that there will always be some people unemployed for structural reasons such as skill mismatches or the fact that jobs may be available in one part of the country while unemployed workers are located elsewhere. In reality the concept of maximum employment has proved to be a moving target as the economy changes. It is for this reason that the Fed rejected the establishment of a numerical target for unemployment as it did recently for inflation with its 2% target. Finally, the long-term interest-rate objective has largely been subsumed under the employment and inflation objectives, based on the idea that if the employment and inflation objectives are met, then long-term interest rates will be in equilibrium and thus be “moderate.”
The second concern with labor market slack is largely independent of the Fed’s dual mandate. It relates to the roles played by labor market slack and the output gap (which is the deviation of the real economy from its potential long-run growth path) in the theoretical and empirical models that dominate the current approach to inflation and monetary policy. These models, in their simplest form, contain no money, and build upon what appeared to be an inverse relationship between unemployment and inflation. That is, as unemployment declines (and hence, labor market slack decreases), inflation should rise. The underlying story, according to the models, is that, as unemployment declines, employers bid up wages and are forced to pass the cost of those wage increases on in the form of higher prices, resulting in an increase in inflation. This view also explains why we hear so much about so-called “wage inflation” from followers of Fed policy. They seem to forget that wages increases associated with increases in productivity are not inflationary.
Interestingly, there is also a large body of literature that suggests that even if there is a short-run tradeoff between unemployment and inflation, there is no evidence that the tradeoff exists in the long run. In fact, Nobel prizes have been awarded to those who have noted that even if there was a short-run tradeoff between unemployment and inflation, it could not be systematically exploited for policy purposes.
Contemporary monetary theory and models have been extended and modified in an attempt to better fit the data; but, as of yet, the basic story remains. Inflation is viewed in this framework as a real-side phenomenon; and – Milton Friedman notwithstanding – there is no central role played by money, the money supply, or the role of money in inflation dynamics. Simply put, then, the existence of labor market slack means inflation will be low.
So, in the current economic environment labor market slack actually plays two largely independent roles in the FOMC’s approach to policy. The existence of slack justifies, from the perspective of the dual mandate, accommodative policies that the FOMC hopes will stimulate growth, boost employment, and ultimately improve labor market conditions. These policies can be pursued without fear of inflation since the existence of slack implies there will be no wage pressure.
What are the risks involved in this policy approach? First, policy makers have no experience emerging from a recession with excess reserves the size they are now and no tested tools to engineer an exit and return to a normal term structure. Second, should interest-rate forecasts and expectations suggest that an acceleration in inflation is on the horizon, these will likely appear when there is still slack in the labor market. Given the normal lag in the effective implementation of monetary policy, will the FOMC be able to change direction quickly enough, after having emphasized labor market slack for so long in keeping inflation low? How much slack in the labor market will the FOMC think is tolerable as it begins to tighten rates? What will the potential political fallout be if rates are tightened while there is still an unacceptable degree of slack in labor markets? Finally, will inflation forecasts be sufficient to justify to the public at large a policy move? Or will the FOMC actually have to see inflation before it acts? It seems likely that it will, given that the Committee has stated that it has a short-run tolerance for inflation above its target, even if the economy is improving. Does this tolerance increase the probability that the FOMC will find itself chasing markets, since interest rates will already have begun to move with inflation? Note that this tolerance also implies that the FOMC expects that inflation may lead a reduction in labor market slack and the return of labor markets to equilibrium. But such a development would then bring into question the inflation dynamic in the Phillips curve/New Keynesian framework that implies that a reduction in slack causes inflation through cost-push price increases.
Bob Eisenbeis, Vice Chairman & Chief Monetary Economist