By Skanda Amarnath
- With elevated inflation, some critics are claiming the American Rescue Plan was too ambitious as fiscal stimulus
- The data suggests today's inflation is due to the speed with which the economy is adding jobs, not the number of jobs added
- As such, critics are really wishing for a slower recovery with a slower pace of job growth
Critics of this year’s American Rescue Plan who built their arguments on claims about the output gap have been feeling vindicated lately. Despite failing to revise their priors in the face of slower state and local aid outlays and premature UI cutoffs, the sheer force of recent inflation prints seems like proof enough to justify their original claims. If inflation is high, then output must be above potential and the labor market must necessarily be “too tight” in terms of employment and wages. Yet even as the this recovery proceeds rapidly, age-adjusted employment rates remain depressed relative to levels attained just 21 months ago.
This shortsighted approach to understanding maximum potential labor utilization purely in terms of inflation is empirically dubious. Acting upon this approach shortchanges American workers in the process. A better way to understand some of today’s inflation is as a byproduct of the speed of employment gains, rather than the outright level of aggregate employment or real output. The flipside of that understanding is to recognize that those calling for rate hikes or fiscal action to slow inflation are--in effect, even if not by intent--arguing that labor markets have improved “too quickly.” Some of the stickier and more cyclical forms of inflation we are seeing today can be attributed to the incredible pace of job growth, in large part due to ambitious fiscal support. It doesn’t make sense to describe this type of inflation as employment exceeding its potential level.
Through its income-generating effects, higher rates of job creation can push up demand for commodities and services that are constrained by slower moving supply side responses (most notoriously for housing). But if employment gains slow in 2022 as the recovery matures and fiscal impulses wane--as most observers and forecasters currently expect--so too will these inflationary strains.
Critics of the American Rescue Plan who feel vindicated by higher rates of inflation seem to imply that we should have targeted a slower employment recovery, even as that recovery remains incomplete. With substantial portions of the ARP remaining unspent - state and local governments are currently figuring out how to deal with unexpected surpluses while a solid segment of UI appropriations were curtailed early - critics appear to be more sensitive to the presence of elevated inflation than the particular size of ARP or the attainable level of employment. Even as it stands now, there is still a substantial--though rapidly closing--gap in the quantity of prime-age employment to be filled.
The basic facts of today’s labor market cut in seemingly opposite directions. 1) We are at once going through an abnormally rapid recovery, and yet 2) we still have not recovered the jobs lost from the pandemic. This is marginally more stark when we consider jobs lost as a share of the labor force or the working age population, rather than total level. Those pointing to depressed labor force participation should be aware that the line between unemployment and non-participation is almost imperceptibly blurry, and prime-age participation rates rose during the last expansion as employment rates continued to make progress.
This should be a problem for “potential output” arguments built around the claim that once the economy exceeds a fixed level of employment or output, persistent inflation emerges. Unless there has been some secretly permanent downside shock to the employment prospects of workers, we haven’t gone past the level of employment that proved consistent with benign inflation outcomes prior to the pandemic. Of course if you’re even indulging in this kind of inquiry, you are required to view potential output as something other than the equivalent of an inflation target. Otherwise, you could just calibrate policy to achieve 2% inflation, employment, output and recessions be damned.
As we have argued elsewhere, “potential output”--especially when divorced from the simpler and more intuitive goal of recovering employment in recessions-- is a deeply flawed metric for calibrating fiscal and monetary policy. It adds little analytical insight when policymakers look for guidance about how to approach trade-offs between strong employment gains and inflation. Any problems in the labor market are essentially rolled into one question: is inflation too high right now? In an environment where housing and other commodities with long lead times for production - and long and complex supply chains - are still responding to elevated demand, it is difficult or impossible to meaningfully disentangle issues of supply from problems in demand.
The level of maximum employment is a moving target, depending both on the demographic structure of the working age population *and* the current path of employment outcomes. The maintenance of higher levels of employment need not create sustained inflation, but moving rapidly to recover lost employment does run the risk of episodic bursts of cyclical inflation. But as the economy fully recovers lost employment, there should be room for rebalancing the prioritization between employment and inflation, depending in part on the time, context, and causal mechanisms that are most relevant to the inflation outlook.
In the current context - one in which employment fell off a historic cliff - policymakers should still be prioritizing employment gains while managing inflation concerns. As the economy digs its way out of the current jobs hole and inflation risks evolve, the appropriate prioritization has room to shift. But we should also remember that today’s inflation readings do not tell us anything about the levels of maximum employment achievable over the longer run.
The pace of job gains will likely slow, and with it, inflation will likely slow as well. Today’s inflation does not tell us that pre-pandemic rates of employment are no longer possible, but it may be telling us how to think about the appropriate speed limits for labor utilization gains as employment rates fully recover from the pandemic. Good policy over the medium term rests on keeping those two ideas separate.