The Fed Struggles to Define Maximum Employment, Needed to Determine Future of Interest Rates

August 31, 2021

Photo courtesy of Financial Times

Fed officials have been struggling to define maximum employment, which has a major effect on how much longer they decide to keep interest rates near zero. Assessing maximum employment – which is the unemployment rate consistent with stable inflation – will be even harder this time around because of two issues. First, officials found that they overestimated it during the previous inflation; this led them to raise interest rates too soon – a conclusion they only came to retrospectively. Second, amidst the pandemic’s numerous effects on the nation’s economic activity, the difficulty in determining how many people who left the labor force last year will come back complicates the situation even further. 

For decades now, Fed officials have used an inflation model – which states that inflation will rise as unemployment falls below a certain level – as their guidance; as a result, whenever unemployment rates neared that specific level, they would raise interest rates to pre-empt inflation. Last year, the Chair of the Federal Reserve, Jerome Powell, added to this guidance a new strategy that would prevent previous mistakes from repeating themselves; the new strategy called on the central bank to allow unemployment to fall as much as it can as long as prices didn’t rise too far above the Fed’s inflation goal of 2%. Since then, the Fed has designed 3 tests that need to be met prior to raising rates for further safeguard: 1) inflation needs to rise to 2%, 2) inflation needs to be expected to run moderately above 2%, and 3) the labor market needs to approach conditions consistent with maximum employment. 

Taking this year’s numbers into consideration, we have already satisfied test 1 and will surely satisfy test 2 – thanks to multiple-industry shortages, supply chain disruptions, and increased travel. The issue facing officials now, however, is that reality has severely outpaced predictions; officials never expected to meet the 2 tests this soon, much less discuss what maximum employment looks like at this point. As a result, officials have been struggling to agree on what constitutes maximum employment and what its future holds. 

Technically, the central bank takes into consideration a number of data points to formulate its definition – ranging from unemployment rates to age groups to workforce participation rates. According to Powell’s speech last month, “favorable hiring conditions, as seen in record levels of job openings and job quitting, suggest job seekers should help the economy cover the considerable remaining ground to reach maximum employment.” He added that “we’re clearly on a path to a very strong labor market with high participation, low unemployment, high employment, wages moving up across the spectrum.” 

Other officials are attempting to narrow down their predictions. Many, including Fed Vice Chairman Richard Clarida and Treasury Secretary Janet Yellen, believe that maximum employment will be reached by next year. Clarida has publicly stated that the labor supply will increase due to a combination of  returned in-person schooling, expired unemployment benefits, and receding concerns about Covid-19. This being said, he didn’t discount the possibility of workers not returning; should this be the case, he predicts that employers will have to raise prices while boosting wages, which will prompt the Fed to face an earlier and/or faster pace of rate increases. 

Aside from maximum employment predictions, officials have also struggled to predict whether the labor market will ever return to pre-pandemic conditions. 

Several believe that it will be an inherently difficult recovery. Dallas Fed President Robert Kaplan, for example, recently stated that the country has “lost somewhere between 4 or 4.5 million workers due to retirements or increased caregiving demands, [which] has tightened the workforce faster than the headline numbers would suggest.” As a result, midsize and small businesses attempting to pass along rising wages will be faced with more persistent price pressures. Additionally, the difficulty in hiring workers at prevailing wages will likely last longer than expected. According to Kaplan, “it is not going to be a short-term thing. It’s not going to get resolved in the fall.” 

On the other hand, some officials deem it much too early to be deciding whether the labor market has been fundamentally altered by the pandemic. According to San Francisco Fed President Mary Daly, “the current debates are similar to those that followed the 2007-09 recession, in which many economists argued that workers had lost skills and weren’t likely to return to the labor force.” She explained that “those people worried that falling unemployment would cause inflation to rise too much, and said the Fed should raise interest rates to prevent that from happening. Instead, as the labor market tightened, many people rejoined the workforce and inflation remained below 2%.” Given the theories circulated as to why we had reached full employment were false, Daly believes “the labor market is far more elastic. When labor demand heats up, we find that full employment is far greater than we might guess if we simply look out there and say, ‘Who’s working today?’” 

Moving forward, Fed officials and others involved will be paying close attention to an upcoming Labor Department report on workforce growth, unemployment and hiring in August, and when the Delta variant is expected to alter the current economic outlook. 

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