Fed policy must not halt the job recovery

The writer is founder and president of MacroPolicy Perspectives

The US Federal Reserve is unique among central banks in that is has a dual mandate to promote both stable prices and maximum employment.

The full employment mandate has a long history from ensuring policymakers fostered growth strong enough to absorb veterans returning from the second world war to becoming a focal point of the civil rights movement of the 1960s and 1970s. It has always been about protecting the most vulnerable workers in the economy, and in doing so ensuring the US achieves higher growth potential.

But Fed chair Jay Powell pointed out during a European Central Bank forum last week that the greatest challenge in the year ahead will be navigating the tension between its dual mandates.

Inflation is running well above the Fed’s 2 per cent target, but employment is still well below levels of engagement before the Covid-19 pandemic.

High inflation has resulted from a combination of an unprecedented shift to spending on goods over services during the pandemic, aggressive and timely fiscal support, pent-up demand after the reopening of the economy; plus Covid-related operational disruptions on global supply chains. Most of these forces are set to moderate over time.

So why is Powell worried about getting the policy mix right? Inflation usually lags behind a recovery but has been “front loaded” this cycle. Central bankers who trained during the high inflation of the 1970s and its volatile aftermath are naturally concerned that the trend of rising prices might become embedded in the economy.

At the same time, the labour market performance of the last economic recovery after the financial crisis and a growing body of research has taught us the importance of policy patience in achieving maximum employment. At the centre of this conclusion is the cycle of participation in the labour force.

Research presented at the Fed’s Jackson Hole Symposium this past August showed the recovery in workforce engagement lags behind the decline in unemployment by months to years. Other Fed researchers showed that this reflected the fact that many people who leave the labour force engage in childcare or schooling and these decisions can lead to an extended period outside the workforce.

A lack of understanding of such cyclical trends may have contributed to policy errors and underemployment in the past.

If the recovery in such engagement lags behind the decline in unemployment, such a policy orientation will prematurely snuff out a jobs recovery with women, non-white and lower-wage workers likely to be affected most, according to past experience.

Powell and other leaders at the Fed very much expect the same lagged recovery in labour force engagement during the current recovery. He and Treasury secretary Janet Yellen have both noted that the US has seen prime age labour force participation fall behind other advanced economies.

In the present environment, pandemic-related disruptions in schooling and health concerns may be keeping people from returning to the labour market. This might be contributing to signals (high numbers of job openings, reports of shortages in some sectors) that the labour market is already tight, even when millions of people who were working in early 2020 are no longer engaged in the workforce.

In addition, the lack of a formal target for maximum employment may also tilt the focus of policymakers to the inflation side of the Fed’s mandate and create pressure to respond prematurely to rising prices.

One option is for policymakers to focus more on ratio of employment to population for people between the ages of 25 and 54 — a group economists refer to as “prime age”. During the past two economic cycles, this ratio never recovered the highs reached in the strong labour market of the late 1990s. As Powell noted last week, low labour force participation is not a good thing and it does not have to be this way.

Robust and early policy support was designed to speed the labour market recovery and there are hopeful signs this cycle will outperform the dismal labour market that followed the financial crisis.

It will take strong leadership, balanced and detailed analysis and clear communication to get monetary policy right over the next few years. That includes keeping as strong a focus on maximum employment as on inflation trends and giving time for the labour market to stage a full recovery.