The Fed’s risky quest for maximum employment

Over the past year, the Federal Reserve (the Fed) has steadfastly stuck to its refrain that tightening of monetary policy will occur only after “labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.” Reading between the lines, Fed officials appear willing to tolerate somewhat higher inflation as long as the labor market continues to heal.

Central bankers appear intent on returning the labor market to its state just prior to the pandemic shock. The U.S. saw historically low levels of unemployment — 3.5 percent for U-3 unemployment rate (the official unemployment rate, which measures those who are jobless but actively looking for work) in Feb. 2020, and 6.8 percent for the broad-based U-6 unemployment rate (which includes those who are unemployed, underemployed and discouraged from seeking jobs) in Dec. 2019. The employment-to-population ratio stood at 61 percent in Feb. 2020. In July 2021, the U-3 unemployment rate stood at 5.4 percent, the U-6 unemployment rate was 9.2 percent and the employment-to-population ratio was 58.4 percent. Compared to Feb. 2020, we still have a shortfall of about 5.7 million jobs. 

In their quest for a full labor market recovery that includes a boost in labor force participation of marginalized groups, central bankers are well-advised to be cognizant of potential challenges in determining full-employment levels in an economy that is undergoing significant structural shifts, many of which were instigated by the pandemic shock. There are two related questions confronting Fed officials at present. How much labor market slack still remains? Are pre-pandemic levels for key labor market metrics attainable without creating significant inflationary pressures? 

The concept of full employment has always been easier to define than to measure accurately. Economists typically refer to the natural rate of unemployment as the level of unemployment that would prevail when the economy is operating at its full potential (actual real GDP is equal to the potential real GDP). The natural rate of unemployment is not zero as an economy will always have some degree of frictional and structural unemployment. Actual unemployment will differ from the natural rate based on changes in cyclical unemployment (which refers to unemployment that is associated with fluctuations in the business cycle). 

Some economists prefer to use the concept of non-accelerating inflation rate of unemployment (NAIRU) instead of the natural rate of unemployment. Since the natural rate of unemployment and NAIRU are theoretical concepts that are unobservable and time-varying, they pose a challenge to policymakers trying to make decisions in real-time. They are typically estimated using statistical procedures, and as such they are very much dependent on the assumptions made about the structure of the economy.

Last year, Vice-Chair Richard Clarida clarified the Fed’s view on full-employment by noting that an “important evolution in our new framework is that the Committee now defines maximum employment as the highest level of employment that does not generate sustained pressures that put the price-stability mandate at risk.”

By downplaying the role of estimated values of NAIRU or the natural rate of unemployment, Fed officials signaled a fundamental shift in their approach. According to Clarida, “going forward, policy will not tighten solely because the unemployment rate has fallen below any particular econometric estimate of its long-run natural level.” 

Recent developments are likely to pose a severe test for the Fed. Backward-looking Fed officials appear far too obsessed with returning the labor market to its pre-pandemic state. They risk ignoring pandemic-induced developments that will accelerate or trigger fundamental changes that are bound to reshape the economy and the workforce for years to come.

Widespread exposure to remote work during the pandemic shock and the ongoing debate regarding hybrid work arrangements are likely to dramatically affect both the geographical distribution of work and work-life balance. We are in for a period of labor market flux as companies, workers and various rule-makers (including tax officials) hash out the details regarding new and more flexible work arrangements (such as differentiated pay scales).

On the technology front, the dramatic surge in e-commerce and e-services is likely to bolster growth of certain job categories at the expense of others. Rising costs and limited labor supply is likely to encourage faster adoption of automation and labor-substituting technologies. Labor market reallocation following the pandemic shock is likely to keep both frictional and structural unemployment elevated for a while. This implies a higher natural rate of unemployment than that observed in Feb. 2020.

Labor force participation rate may also not return to levels observed just prior to the pandemic. Multiple factors are limiting the size of the U.S. labor force, and not all of them are temporary. Many in the 55 and above age group are choosing to retire early as concerns about health risks and the recent surge in asset prices make early retirement an attractive option. It is also unclear if all of the women who left the workforce will soon return to the labor market.

The extent of labor market slack may therefore be overstated. Many of the existing labor market frictions are going to take some time to play out. Consequently, the Fed faces the risk of making a serious error on the inflation front by continuing to stick with ultra-accommodative monetary policies. Upward pricing pressures are persisting as underlying demand remains robust even in the face of widespread supply constraints.

The Fed’s quest for maximum employment may prove to be quixotic if it sticks to the unrealistic goal of returning the labor market to a state prevalent just prior to the pandemic shock.

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.