This is the first of four articles examining monetary and fiscal policy and the Federal Reserve’s response to the overriding issues of today’s economy. This article examines the Fed’s challenge in meeting its mandate for full employment. The second looks at the Fed’s other mandate, for price stability. The third discusses the natural rate of interest and its impact on Fed policy. The last examined the reflation of the economy and the risks that remain. This article was updated on Feb. 2 to reflect changing market conditions.
Despite recent gains in the labor market and rising inflation, we think that the Federal Reserve will act in measured steps as it removes its financial accommodation. Instead, monetary policy will continue to adapt to a new set of circumstances within the labor market and in regard to the potential growth of the economy.
We are looking for a gradual acceleration of the Fed’s policy normalization beginning no later than the second quarter.
As we look ahead to the eventual transition of the pandemic into a more manageable endemic—once the omicron variant eases—we are looking for a gradual acceleration of the Fed’s policy normalization beginning no later than the second quarter. There is the caveat of delayed action, should new outbreaks emerge.
As for fiscal policy, Congress seems unlikely to pass the second half of the Biden administration’s infrastructure revitalization program. After allocating money for rebuilding the nation’s failing transportation and energy systems, this half of the administration’s program was focused on boosting the productivity of the labor force and the transition to an economy centered on advanced manufacturing and innovation.
These decisions, by the Fed and Congress, all will have an effect on the climate for investment.
Low interest rates will continue to add to the profitability of private capital investment, with debt paid off in deflated dollars.
And government investment in infrastructure and the productivity of the labor force would facilitate the global competitiveness of those businesses and will form the foundation for higher wages and wealth accumulation of the U.S. labor force.
With fiscal investment either already allocated or at the mercy of political pressures, our discussion that follows—the first in a series—centers on monetary policy and the Fed’s dual mandate for full employment and price stability.
This is of increasing importance as the pandemic continues to have a profound impact on the labor market, global supply chains and inflation.
What constitutes full employment?
As workers have returned to the labor force, incomes have risen and the unemployment rate has dropped to 4.2%, a robust discussion has followed over what constitutes full employment in the American economy.
For the Federal Reserve, it’s more than an academic debate. Congress, after all, has given the Fed a dual mandate of maintaining price stability and achieving full employment. These mandates will gain renewed focus on Friday, when the Labor Department releases the employment figures for December.
The Fed defines full employment as having a 4% unemployment rate. That’s down from the 5% of previous decades and reflects a shifting economic landscape. Broad demographic changes, a quicker pace of innovation and restrictions on immigration have all expanded what constitutes full employment. In our estimation, the definition of full employment is closer to a 3.5% unemployment rate, or lower.
But at the same time, achieving this mandate can lead to pressures from the other half of the mandate.
Now, with inflation having accelerated to the highest level in decades, policymakers face a dilemma: The Fed must achieve full employment while taming price increases. That means moving its policy variable on inflation—the core personal consumption expenditures index—back to 2% from the current 4.7%.
Indeed, that process is about to begin. We are looking for a gradual acceleration of the Fed’s policy normalization beginning no later than the second quarter ,with the market anticipating three to four increases in the federal funds rate this year, all of which could change if the omicron variant inflicts more damage to the economy.
In the end, the American workforce was dealt a significant setback during the pandemic and has yet to fully recover. Even as the unemployment rate nears what the Fed considers full employment—we see it ending the year closer to 3.5%—that goal has yet to be achieved and will require a careful balancing act by central bankers.
Redefining the dual mandate
In a standard Taylor Rule model of central bank behavior, the Fed responds to an overheating economy by increasing interest rates to counter a tightening labor market in which wage pressures further add to rising prices.
The Federal Reserve faces the dilemma of achieving full employment while taming inflation.
Current estimates of the equilibrium conditions in the labor market now center on an unemployment rate of 4%. That is, at any one time, 4% of the labor force participants are expected to move from one position to another within a growing economy capable of offering employment choices for workers.
Stability of prices is defined as long-term average price increases of 2% per year, with the 2% inflation target thought to be consistent with sustainable economic growth and sufficient consumer demand to bid up prices.
When inflation is averaging lower than 2%, that is a sign of insufficient demand and economic stagnation, as was most recently the case during the decade-long recovery from the Great Recession.
All of this must be balanced with the demographic and societal changes that seemingly exploded across the economy during the two years of the pandemic. The Fed was not caught unaware and had already adopted policies to address these overriding issues.
The mandate for full employment
The tightness of the labor market is measured by the gap between the current rate of unemployment relative to its equilibrium level. If the unemployment rate is consistently lower than the equilibrium rate, that indicates the potential of rising wages as employers compete for a smaller pool of labor and an overheating economy. Under those conditions, the Fed usually raises interest rates.
But if the unemployment rate is consistently higher than its equilibrium rate, that indicates an underperforming economy, and the Fed seeks to facilitate investment and spending by pressuring interest rates lower.
Over the past 20 years, the equilibrium unemployment rate had been assumed to be about 5% in general terms. That is, in normal times, about 5% of the labor market is transitioning from one job to another as businesses close or as employees exercise their choice in employment.
Recall that labor market churn is a sign that employees are able and willing to advance themselves, growing the economy. The last time the unemployment rate dipped below 4%, during the economic boom of the dot.com years and then again in 2019, the consensus was that the equilibrium rate had briefly dipped to 4.5% in the late 1990’s and 4% before the pandemic.
Formal estimates by the Congressional Budget Office of the noncyclical rate of unemployment—the rate of unemployment caused by all factors other than the business cycle—peaked at 6% in 1979, dropping to 4.5% in the third quarter of last year. Expectations are for that slow decline to continue over the next decade.
So if the unemployment rate has broached its equilibrium level—and prices are rising—why have the central banks in the United States, Canada and the U.K. balked at raising their policy rates off the zero bound?
Given the changing demographics of the labor force and the diminished reward for working in traditional occupations, we have reason to think the monetary authorities are looking past the traditional U3 rate of unemployment, which as we’ll show applies only to a segment of the population.
Given the significant changes in an evolving labor market, we’d argue that the target for the equilibrium level of unemployment should be 3.5% or lower.
Here are some factors that suggest that an accommodative monetary policy stance—coupled with investment by the fiscal authorities in the labor force—is required until the supply of labor is replenished and until all segments of society are rewarded for their labor.
The decline in the attractiveness of employment
People don’t necessarily work because they want to. The fact that many people work and buy lottery tickets speaks volumes about their motivations.
In recent decades, the rewards of working have stagnated to the point that wage growth has barely kept up with price increases.
In the month before the pandemic, hourly wages adjusted for inflation were growing at 0.5% per year. Factor in added costs like child or family care, or health care, and the rational path of behavior for some in the labor force to keep working may not hold true anymore.
If one argues that the wage growth before the 1980s was an unsustainable overreach of union power, then the decline in wages since those days, and before the pandemic, must be attributed to the decline of workers’ bargaining power brought about by the availability of cheap labor in the South and then offshore.
What’s more, advances in technology and automation have further narrowed the demand for labor, with automation reducing the need for unskilled labor.
The era of low wages, automation and declining opportunities for those left behind by these changes—often in traditional manufacturing roles—has resulted in social dislocation and disengagement that affect a substantial segment of the nation’s workforce.
Away from those permanent losses of manufacturing jobs, the rational behavior of underpaid employees has been to forego the diminished return on selling your labor in the service sector. We see this in the 20-year decline of employment among 25 to 54-year-olds, whom we characterize as prime-age workers.
The percentage of prime-age workers relative to their population typically plunges during recessions before increasing again during a recovery. That pattern coincides with the cyclical demand for workers and their bargaining power for higher wages.
During the era of women joining the workforce from 1960 to 2000, the prime-age employment ratio increased to successively higher rates after each recession. That trend seemingly ended with the 2001 recession. Since then, both men’s and women’s labor force participation has been in decline as automation and offshoring have eroded employment choices and rewards.
As businesses shed jobs in favor of capital investment during the economic shake-out, we can expect further declines in the demand for less-skilled labor, resulting in stagnation of average wages, despite the recent uptick in wages at the lower end of the income spectrum.
We expect that the labor force participation rate of prime-age workers will remain historically weak, as younger people delay their entry into the labor force, jobs in the digital economy require more skills, and older workers choose to retire or become self-employed.
Within this shrinking pool of qualified labor—and with fewer immigrants to replace missing workers—that implies that all available hands will be required to perform the work of increasingly technical tasks.
But that implies higher wages for only a limited subset of the labor force and a lower equilibrium level of unemployment.
The pandemic’s toll
Economic growth is sustained by investment in capital and the growth of the labor force. Both have been in decline in the United States since the 1980s. Nonresidential fixed investment has been in general decline since the dot.com era, as has the labor force participation of both men and women in their prime working age.
Our analysis shows a 65-year decline in the labor force participation rate of prime working-age men from the early 1950s through about 2015. An upswing took place after the 2015 mini-recession, but then those gains stalled when the 2018 trade war developed into a late-cycle slowdown. For women, a similar declining trend developed after their participation peaked in 2000.
The labor force has yet to fully recover from its collapse during the pandemic. The number of prime working-age men in the labor force was reduced by 4.25% at the depths of the economic shutdown, with a deficit of 1.3% remaining. The number of prime working-age women in the labor force was reduced by 5% during the pandemic, with a 2.1% deficit still to be recovered.
In past recoveries, though, the labor force has rebounded more fully. What’s different this time?
There have been more than 70 million COVID-19 infections in the United States and more than 900,000 deaths. Furthermore, studies reported by UCDavis Health suggest that 25% to 33% of infections, no matter how severe, can lead to long-term debilitating consequences.
All of this has an effect on the labor force, as people opt out of traditional jobs or have been forced out after being infected or having their business closed.
In one sense, these decisions are entirely rational: Older people are retiring, younger people are starting their own businesses or seeking nontraditional work options, and parents who are priced out of day-care options are staying home with their children.
The ethnicity of unemployment
As the Fed has sought to stabilize the economy with aggressive monetary policies, it has spoken openly of the need to expand employment opportunities to a broader population.
Until recently, the main focus on the equilibrium level of unemployment relied on data that accounted for the prospects of white workers. But white workers are less likely to be unemployed than Black or Hispanic members of the labor force. This disparity grows more pronounced during economic downturns.
Consider the different unemployment rates in November 2020: For white workers, the unemployment rate was 3.7%, but was 6.7% for Black workers and 5.2% for Hispanics. That gap has persisted over the modern industrial era, with the unemployment rate averaging 5.5% among white workers, 11.8% for Blacks, and 8.7% among Hispanics. (The average Asian unemployment rate is available only since 2003 and is averaging 4.9%.)
This gap is what the Federal Reserve refers to when it speaks of the need to address the persistent inequality of opportunity, and the need for its policy stance to remain accommodative until all members of society are able to take a full role in the economy.
This will be one of the more contentious issues as policymakers attempt to find the balance between price stability and a broader definition of full employment that is inclusive of all ethnicities.
The opportunity for a midcourse correction
It now takes fewer workers to produce goods and, despite the growing inequalities, there is a surplus of cash in the form of household savings to allow a segment of the population to pursue other endeavors.
This has resulted in a shrinking workforce. Only 81% of the prime working-age population is now participating in the labor force, down from the 92% rate of 20 years ago. Although we expect that ratio to increase as the recovery develops, the pattern over the past two decades is for the noncyclical rate of unemployment to continue to decline.
Is the shrinking of the workforce the fault of the social safety net? We would argue that the pandemic and the loss of opportunity has more to do with people leaving the workforce than with transfer payments from the government like unemployment benefits or social security payments.
The upshot is that if less labor is needed and if fewer workers are willing to take traditional jobs, then perhaps we should expect the Fed to consider that the current 4.2% unemployment rate is not a sign of an overheating economy.
Rather, we would hope the monetary authorities continue to see the need to ensure a widespread recovery of employment among all classes of workers.