By Skanda Amarnath and Alex Williams
As we wrote last week, we are rapidly approaching labor market conditions that the Fed could validly consider “maximum employment” over the short run. With inflation running hot, market commentators and lawmakers are calling for the Fed to blink on its commitment to maximum employment and revert to the policy preferences and habits that have shortchanged American workers during and after recessions. Critical to the Fed successfully achieving maximum employment over the short run and the longer run is a commitment to, and a communication of, “maximum employment” that is Credible, Broad, and Inclusive. Without this, the Fed risks reneging on the forward guidance it provided earlier in the pandemic, while abdicating its responsibility to the “maximum employment” side of its dual mandate.
Credible
The idea of “credibility” is a familiar one in the world of central banking in the context of targeting inflation. Today, however, the Fed needs to build credibility with respect to its mandate for maximum employment. In the face of historically high inflation readings, the Fed is at risk of backsliding on its stated commitments to maximum employment. Since September 2020, the FOMC meeting statement has reflected a commitment to current interest rate policy “until labor market conditions have reached levels consistent with the Committee's assessments of maximum employment.”
First, the Fed must stick to the “maximum employment” component of existing forward guidance. Failing to adhere to this forward guidance risks hampering the power of future state-dependent forward guidance. Even under the current circumstances, interest rates are still likely to be constrained at the zero lower bound in the next recession and thus credible forward guidance will still be a major part of the unconventional forward guidance toolkit. If Fed commitments are watered down ex-post, the effects of future commitments on financial conditions will also be diminished and more likely to be misaligned from rapid achievement of maximum employment.
It is true that the Fed has some “escape hatches” from these commitments, such as when they see threats to inflation expectations and financial stability. However, if the Fed chooses to cite the threat to inflation expectations as an escape hatch, they should be transparent about their evidence and reasoning, and that evidence and reasoning should be reflected in substantially higher core and headline inflation forecasts for 2022, 2023, and 2024. Make no mistake: the Fed should strongly disfavor such an approach even right now. A penchant for using such escape hatches will inevitably lead the public to second-guess the power of subsequent commitments and impose long-term costs on the Fed’s policy space.
While inflation is giving some at the Fed heartburn now, we have seen faster labor market gains than any recovery in living memory. Today’s forward guidance remains a huge step forward beyond the Evans Rule guidance, which would have opened the door to liftoff at least 5 million jobs ago, on the strength of unemployment alone. If current trends hold for a few more months, the pre-pandemic labor market, inclusive of both wage growth and age-adjusted employment-to-population ratios, will be reached.
Ultimately, the Fed has built substantial credibility as an inflation-fighter, but comparatively little as a recession-fighter. Much of today’s inflation can be traced back to anxieties about the scale of fiscal and monetary response to the threat of the pandemic in early 2020. Automakers saw month-over-month sales declines that looked like a Great Recession 2.0 and slashed orders for intermediate parts. At the same time, rental car companies were forced into bankruptcy and liquidated the fleets they are now buying back as expensive and scarce used cars.
If the Fed is able to build a reputation as a credible recession-fighter, we will not see that same level of panic the next time there is an exogenous recessionary shock. Businesses learned from the Great Recession that there were no cavalry coming to their rescue, and learned that the best way to survive was to strip assets and cull labor, perfectly suboptimal from a broader social perspective.
Broad
It is critical for the Fed to take a broad view of what counts for maximum employment and not lean on the narrowness of a single labor utilization measure. As with the notion of “credibility” above, we have expanded at length on how the Fed can sufficiently broaden the set of indicators used to evaluate “maximum employment” in our piece, Beyond The Phillips Curve.
The easiest way to embed a commitment to a broad notion of maximum employment would be to formally set forth additional indicators that must necessarily supplement conventional measures of employment and labor utilization for assessing “maximum employment,” with wage growth the most obvious place to start.
Chair Powell has so far seemed open to this approach, citing indicators like the prime-age employment-population ratio and the labor force participation rate in press conferences. He has also emphasized the importance of income measures like the Employment Cost Index (ECI), most memorably in his comment that, “to call [the labor market] hot, you have to see some heat” in terms of wage growth.
Of course there are other indicators that reflect spare capacity and the disparate impact of cyclical employment shortfalls along the lines of race, income, and education. The Fed should ideally have an approach to communication that folds in those effects, especially as the labor market changes over time. But at least as a starting baseline, maximum employment assessments need to formally reflect robust measures of both labor utilization and wage growth.
Inclusive
An inclusive understanding of “maximum employment” resists the narrow definition of the unemployment rate and accounts for the disparate impacts that recessions impose on the labor market. For example, the labor force participation rate - the denominator in any unemployment rate calculation - varies cyclically, with marginalized groups facing disproportionate impact. Prospective workers in different demographic groups are often written out of the labor market during recessions only to re-enter the workforce as the recovery progresses. This artificially shrinks the measured unemployment rate for black workers, leading to premature declarations of “full employment” and premature policy tightening. Unemployment numbers can’t tell the whole story and definitions of “maximum employment” must make space for cyclical nonparticipants, particularly in prime working age cohorts, in order to be truly inclusive.
Recessions are not the same for all demographic groups, and targets for short-term maximum employment ought to reflect these differences if the Fed is serious about being broad and inclusive. While the labor force participation rate for black and white workers both made a full round-trip over the course of the 2008 recession and recovery, the rate for black workers troughed at a lower rate than for white workers.
The last-hired first-fired nature of the labor market experience is both deeply unfortunate and a process that interacts with business cycle dynamics. Excluding these non-employed workers from more formalized measures of maximum employment (like the FOMC’s “longer run projection for the unemployment rate”) serves to double-down on the disparate impact of recessions on disadvantaged groups.
Taking the idea of “maximum employment” seriously means reckoning with the disparate impact of recessions on both the unemployment and participation rates of various demographic groups. Understating the number of people who want to work does help the fiscal and monetary authorities achieve their goals faster in terms of a measured unemployment rate, but it does not tell us where even maximum employment over the near-term may lie. To do that - and to be truly inclusive - the Fed needs to emphasize metrics like the prime-age 25-54 employment-to-population ratio, which look well beyond the narrowness of the U-3 unemployment rate and the disparate impacts it imposes.
As the pandemic winds down and the recovery continues, it is critical for the Fed to use this opportunity to build its credibility on its “maximum employment” mandate by sticking with a broad and inclusive definition of “maximum employment” that is at least consistent with what was known pre-pandemic. With policymakers and commentators beginning to take stock of how actions undertaken early in the crisis have affected the later outcome, it is more important than ever to stress the importance of having fiscal and monetary institutions whom the public understand as credible recession-fighters and employment defenders.
