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.
Diane Swonk, chief economist at Mesirow Financial., talks about the February U.S. employment report released Friday and the outlook for the labor market. (Source: Bloomberg)
Battling inflation vs. unemployment.
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.