‘In what I consider a landmark speech at The Economic Club of New York: “Getting Back to a Strong Labor Market”, Powell starts of with:
Today I will discuss the state of our labor market, from the recent past to the present and then over the longer term. A strong labor market that is sustained for an extended period can deliver substantial economic and social benefits, including higher employment and income levels, improved and expanded job opportunities, narrower economic disparities, and healing of the entrenched damage inflicted by past recessions on individuals' economic and personal well-being. At present, we are a long way from such a labor market. Fully realizing the benefits of a strong labor market will take continued support from both near-term policy and longer-run investments so that all those seeking jobs have the skills and opportunities that will enable them to contribute to, and share in, the benefits of prosperity.
The Broad Responsibility for Achieving Maximum Employment
Seventy-five years ago, in the wake of WWII, the United States faced the challenge of reemploying millions amid a major restructuring of the economy toward peacetime ends. Part of Congress's response was the Employment Act of 1946, which states that "it is the continuing policy and responsibility of the federal government to use all practicable means . . . to promote maximum employment." As later amended in the Humphrey-Hawkins Act, this provision formed the basis of the employment side of the Fed's dual mandate. My colleagues and I are strongly committed to doing all we can to promote this employment goal.
Historically, the Fed´s belief in the existence of a Phillips Curve, according to which a level of unemployment below its '“natural” (or NAIRU - non accelerating inflation rate of unemployment) would advise a tightening of monetary policy to cool the economy and avoid an increase in inflation when unemployment approached the “natural” rate. Unemployment would rise, but that was the price that had to be paid to avoid an increase in inflation.
After seeing unemployment fall to 3.5% before the pandemic hit without any increase in inflation materializing, the Fed now believes it can pay attention only to shortfalls in the unemployment rate. Powell´s five main points in his speech, therefore, are:
1. U.S. a long way from full employment
2. Unemployment in practical terms around 10%
3. Need fiscal and monetary support
4. Fed not thinking about tapering assets
5. No sustained rise in inflation seen
In my recent post, “Sometimes monetary policy gets it right. Sometimes it gets it wrong (and sometimes it is surprised)”, I showed that monetary policy “gets it right” when it obtains nominal stability, by which I mean a stable level of nominal spending (NGDP) growth (the level path along which nominal stability is observed is also important, but I´ll leave that out for present purposes).
The unemployment chart below shows that over the last 3 decades, there were three periods of protracted fall in the unemployment rate. The first two ended when the unemployment rate fell to levels considered “dangerously” close or even below the level consistent with the perceived “natural” rate. In the last one, the unemployment breached the most optimistic level of “natural”, but then, the pandemic hit. (Shaded areas denote recession).
The next charts show the unemployment rate during the periods when it fell continuously and the associated rate of inflation.
The “bliss” (falling unemployment & low and stable inflation) end in the first two periods when the Fed, “frightened” by the low rate of unemployment, tightens monetary policy (constrains the growth of NGDP).
Note that the three periods of falling unemployment and low/stable inflation are associated with nominal stability (stable growth of NGDP).
That´s the “monetary trick” Powell and the Fed need to learn. They do not have to focus on the labor market, like Powell suggests in his speech.
If he does so, the risk that he´ll get monetary policy wrong increases significantly. The result could resemble the 1970s, when Arthur Burns, “oblivious” to the fact that inflation is a monetary phenomenon, completely lost nominal stability, with NGDP growth showing a continuous uptrend.
There is nothing novel about this assertion. During the second half of the 1990s, the FOMC dedicated a lot of time to discussions of the Phillips Curve and NAIRU. The upshot of this discussion took place in the June 2000 FOMC Meeting with William Poole, then President of the St Louis Fed, giving the “closing arguments”:
The traditional NAIRU formulation views the wage/price process as running off a gap–a gap measured somehow as the GDP gap or the labor market gap. And the direction of causation goes pretty much from something that happens to change the gap that feeds through to alter the course of wage and price changes.
I think there is an alternative model that views this process from an angle that is 180 degrees around. It says that in an earlier conception, either through a determination of a monetary aggregate or through a federal funds rate policy, monetary policy pins down the price level or the rate of inflation and, therefore, expectations of the rate of inflation.
Then the labor market settles, as it must, at some equilibrium rate of unemployment. Where the labor market settles is what Milton Friedman called the natural rate of unemployment. But the causation goes fundamentally from monetary policy to price determination and then back to the labor market rather than from the labor market forward into the price determination. I certainly view the causation in that second sense.
I think it is the willingness of the Federal Reserve to stamp out signs of rising inflation that ultimately pins down expectations of the price level and the inflation rate. Now, the labor market has been clearing at a level that all of us have found surprising [just look at the NGDP growth unemployment chart for 1992-200 above]. But I don’t think that necessarily has any particular implication for the rate of inflation, provided we make sure that we are willing to act when necessary. (pg 61).
If only new FOMC members had a “refresher course” on long-ago held discussions at their regular meetings, maybe they would not have to “relearn” things at very turn!