By Skanda Amarnath
The Fed now recognizes that its interventions have helped to create millions of jobs and promoted a better equilibrium in the long run. A deeper shift to its reaction function is now needed.
Fed Communication Suggests Recognition Of A New Reality
Chair Powell’s recent statements reveal a fundamental shift in how the Fed communicates. At the June FOMC press conference, Chair Powell noted that “the reason why we say ‘sustain the expansion’ is [that]…communities… are being brought into the benefits of this expansion that hadn’t been earlier.” He reiterated this at his most recent Humphrey-Hawkins testimony:
“What we’re hearing…from people who work and live in low and moderate income communities is that…with this tight labor market, employers…are waving…issues that might have prevented people from being in the work force.”
Monetary policy is no panacea but its impact on how macroeconomic benefits are shared and maintained extends beyond the short run. With this knowledge, the Fed has an elevated responsibility to stay attentive to the risk of slower growth, even amidst a low headline unemployment rate.
Despite a mandate to pursue “maximum employment,” the Fed has generally preferred to set the bar much lower. Even as former Chair Bernanke sought justification for easier policy in the years following the financial crisis, he felt compelled to offer the following caveat:
“Monetary policy — as a general rule — cannot influence the long-run level of employment or unemployment. And that’s certainly correct. What we are trying to address is the short run cyclical gap.”
Philadelphia Fed President and esteemed academic Charles Plosser took an even stronger view that monetary policy was ill-equipped to reduce a 9% unemployment rate:
“You can’t change the mortgage broker into a computer expert in a manufacturing plant very easily. Eventually that stuff will sort itself out. People will be retrained and they’ll find jobs in other industries. But monetary policy can’t retrain people. Monetary policy can’t fix those problems.”
The Bernanke-Plosser debate was waged on the common ground that in the longer-run, monetary policy had virtually no relevance to the labor market — only to inflation. The only question to be debated was whether conditions could be improved in the short run.
Thankfully, current FOMC members are starting to take a more expansive view. Despite the Great Recession officially ending more than 10 years ago, the Fed can still play a supportive role in overcoming persistent sources of economic weakness. Chair Powell noted that for members of low and moderate income communities:
“They haven’t had…a bull market…a booming economy. What they have had is low unemployment, lots of social problems. And just now, you have… companies who want to hire and are…providing opportunities for people to come into the labor force to an extent not seen in quite a long time.”
The Long Run Is Shaped By The Short Run
Judging by the evolution of the FOMC’s Summary of Economic Projections, other FOMC members see this issue similarly. The estimates of the longer-run equilibrium unemployment rate appear to be sensitive to short run cyclical developments (see figure 1). According to the textbook, this equilibrium unemployment rate is supposed to be guided by factors that are independent of central bank policy. Yet if you take the Fed’s more recent set of statements at face value and observe some of the recent evidence, then it is obvious that through its short-run interventions the Fed can shape longer-run labor market outcomes.
The Fed Has Been Effective In Supporting Labor Market Progress
To the Fed’s credit, the post-crisis period has been marked by a strong bias towards easing financial conditions at moments when employment growth was falling and unemployment declines were at risk of reversing (see Figure 2). Even when constrained by the zero lower bound, the Fed was able to take actions that led to lower borrowing costs for the private sector and a more competitive exchange rate (Neely 2015).
- Just as employment and GDP growth were slowing in the latter half of 2010 amidst state and local government layoffs, the Fed was ready to support a weaker dollar and lower mortgage rates with a second round of large-scale asset purchases (LSAP 2 / QE2).
- In the latter half of 2011, when tighter fiscal policy and the European sovereign debt crisis raised the risk of a double-dip recession, the Fed stepped in with the maturity extension program (MEP / “Twist”) and stronger forward guidance.
- In 2012, ongoing fiscal austerity and the fiscal cliff forced the Fed to engage in an indefinite third round of LSAPs (QE3) and commit to the Evans Rule.
- More recently, the Fed has adjusted to headwinds from the global economy and the domestic energy sector by postponing hikes in 2016 and reversing course altogether in 2019.
Signs of stalling labor market progress were met with sufficient monetary easing to extend the expansion.
The Fed’s Reaction Function Must Move Beyond The Natural Rate Hypothesis
The Natural Rate Hypothesis centers around the idea that there exists only one unemployment rate that is consistent with stable inflation. Going below that natural rate of unemployment will ultimately prove short-lived and excess inflation will be the only lasting result. As a result, the Fed tends to be guided by policy rules that center around keeping the unemployment rate close to its estimated natural rate. However, because such estimates are highly imprecise, policy is likely to be error-prone if it is set as a direct function of the estimated natural rate.
The Fed’s over-tightening in the latter half of 2018 was in part the result of an excessive dependence on such estimates. The Fed assumed that with the unemployment rate going beyond its natural rate, higher policy rates would be needed over time in order to keep inflation under control. Instead, inflation undershot the Fed’s forecasts and estimates of the natural rate of unemployment have since moved lower in 2019. As a result, the Fed has had to reverse course and reduce interest rates after raising them throughout 2018.
It is no longer appropriate for policy to be so closely tied to the Fed’s sticky estimates of the natural rate of unemployment. The cost of repeating the mistake of 2018 is simply too high. The Fed needs to clarify and formalize a new reaction function that reflects the labor market benefits it now seeks to preserve and sustain. If it does not, the public will remain confused about the Fed’s willingness to ease while the headline unemployment rate remains low.
One way of doing so would be to aim to put a floor under gross labor income growth. Such a framework would make clear to the public that the anticipation of weak employment and wage growth would offer sufficient justification for easing. This would still be consistent with the rate cut that was delivered in July. It would also give the public more confidence that it would ease aggressively enough in response to early signs of labor market deterioration.
The Fed Should Take Responsibility For Its Role In Preserving Tight Labor Markets
The Fed deserves to take some credit for its role in sustaining the expansion despite numerous headwinds. Nonetheless, these newly recognized benefits from a long expansion and a tighter labor market raise the stakes of future policy decisions. Timely support for aggregate demand has been a necessary condition for ensuring that this expansion continued. The Fed has helped to undo damage that was previously attributed to structural causes.
Only recently has the Fed started to appreciate the full impact of its policies. The Fed’s reaction function now needs to change to reflect this reality.