For three decades, the Federal Reserve has believed that the path to economic prosperity is in fighting inflation. But it is realizing that is no longer enough.
The central bank for the first time is making an attempt to shape the labor market, believing that reducing unemployment is the key to the recovery. It has tied billions of dollars of stimulus money to the health of the labor market. It has vowed to keep interest rates at historic lows until the unemployment rate is at least 6.5 percent. Top officials have begun addressing the issue in increasingly urgent and personal tones.
The focus on jobs represents a historic shift for the central bank that began with the 2008 financial crisis and has intensified in the face of four years of middling economic growth. But how much influence the central bank wields over unemployment remains an open question: It cannot direct businesses to hire or inspire entrepreneurs to create jobs. Meanwhile, warnings have grown louder that the quest to bring down unemployment could have unintended consequences — including stoking inflation that a generation of central bankers worked to tame.
Yet there remains consensus inside the Fed that the gamble is worth it. There is even a sense that partisan gridlock on Capitol Hill means that the central bank alone is in a position to help put Americans back to work.
The high unemployment rate has “imposed huge burdens on all too many American households and represents a substantial social cost,” Fed Vice Chairman Janet L. Yellen said in a speech last week. “I believe it’s appropriate for progress in the labor market to take center stage in the conduct of monetary policy.”
The Fed officially is charged both with ensuring price stability and maximum employment — its “dual mandate.” But that’s not exactly how it has viewed its mission in the past.
Historically, inflation has been at the top of the Fed’s agenda. That’s partly because the Fed’s primary power is the ability to alter interest rates.
The effect that has on inflation has been well established: When prices rise too fast, the Fed raises its target for interest rates and slows down growth. When prices fall too low, it lowers the target to encourage consumers to spend money, driving prices back up.
Part of the challenge of focusing on the unemployment rate is first determining how low it can actually get. Fed officials’ estimates range between 5 and 6 percent, but the real number may be unknowable.
In addition, the connection between interest rates and employment gets a little murky. Low rates stimulate consumer demand and boost businesses’ bottom line. But the recovery has shown that doesn’t always translate into job growth. Many companies remain spooked by the recession and are not hiring new workers even though sales are up. And the Fed ultimately has no control over structural changes to the economy — such as the shift away from manufacturing to service jobs — that determine the unemployment rate in the long run.
The central bank’s role in propping up the labor market will be one of the defining debates inside the Fed over the next few years. Although Fed leadership remains committed to stimulating the economy until job growth picks up, that effort has taken it into uncharted policy waters, drawing both internal and external criticism.
“I have become increasingly concerned that many people inside and outside our government have come to expect too much from monetary policy,” Philadelphia Federal Reserve Bank President Charles Plosser said in a recent speech. “If society pressures monetary policy to over-reach its capabilities, it will surely fail and, in doing so, will undermine not only the Fed’s credibility but also monetary policy’s ability to deliver on the goals that it is most capable of achieving.”
Fed governor Jeremy Stein has warned that years of ultra-low interest rates could be creating new bubbles that threaten financial stability. Richmond Federal Bank President Jeffrey Lacker — who dissented from every Fed decision last year — said the attempts at stimulus are not filtering through to the economy. In a hearing on Capitol Hill last week, Rep. Jeb Hensarling (R-Tex.) worried that the central bank will not be able to retreat from its new position.
“There is a growing consensus among economists that the Federal Reserve’s road has led us to the monetary outer limits,” Hensarling told Fed Chairman Ben S. Bernanke during a recent hearing. “And if one remembers that classic science fiction television program, typically the episodes did not end well.”
Bernanke has bristled at the suggestion that he is soft on inflation. He has argued that because prices have been rising less than the Fed’s 2 percent target, low interest rates could help boost employment and bring inflation up, closer to the Fed’s goal. And he has boasted that his inflation record has been the best of any Fed chairman since World War II.
But keeping prices stable and employment robust do not always work hand in hand. If inflation began to rise and the Fed raised interest rates, the slowdown in economic growth could throw more people out of work. The central bank realized this potential conflict as soon as Congress tasked it with the dual mandate in 1978.
“If anybody abroad thought [this law] would be taken seriously, we would be disavowing all our anti-inflation effort,” then-Fed governor Henry Wallich said, according to transcripts of Fed meetings compiled by the St. Louis Federal Reserve Bank.
The Fed chairman at the time, William Miller, suggested what he called an “ingenious” solution that allowed the central bank to keep inflation the priority while acknowledging the dual mandate. Promoting low inflation, he said, was the best way to create a stable environment for businesses and the economy — and keep Americans working.
That idea became the Fed’s mantra for a generation. Even when Fed Chairman Paul Volcker’s aggressive battle against inflation led to double-digit unemployment during the 1980s, the Fed’s strategy was justified when the economy stabilized a few years later.
But the financial crisis presented the Fed with an entirely new dilemma. Inflation has been in check while the unemployment rate remains stubbornly high.
With the crisis in full swing in December 2008, the Fed, in its primary policy statement, addressed the labor market for the first time since the dual mandate was established. Last year it took an unprecedented step of tying its benchmark interest rate to the unemployment rate. Some Fed officials are even contemplating what once was an unimaginable scenario: allowing inflation to creep up if it means more people can find a job.
Take the evolution of Minneapolis Federal Reserve Bank President Narayana Kocherlakota. Once viewed as an inflation hawk, he has since become convinced that the Fed has the tools to bring down the unemployment rate. His target is one of the lowest of central bank officials. “If you say you’re always going to be raising rates before you get to full employment, you’re defeating yourself,” Kocherlakota said in a speech. “You’re tying your hands behind your back.”