The Fed has two Congressional mandates that are supposed to guide its monetary policy: 1) maximum employment, and 2) price stability. With regard to the employment mandate, the Fed has historically operated using a concept known as NAIRU, or the Non-Accelerating Inflation Rate of Unemployment. The Fed’s goal, based on NAIRU, is to reduce the unemployment rate as low as possible, but not so low as to cause outsized wage gains. The underlying assumption with regard to NAIRU is that if the labor market gets too hot (the demand for workers far exceeds the available pool of supply), there will be upward pressure on wages. Those wage pressures, it is widely believed, will eventually lead to more widespread inflationary pressures throughout the economy. Therefore, it’s better to nip inflation in the bud before it can take root and force a more dramatic response (see Paul Volcker).
It’s important to note that there is friction in the labor market. Because of factors like new technologies (that replace jobs), skills mismatches, and just benign factors like career changes, there will always be some percentage of the labor force that is not employed. That is to say, NAIRU is above zero. But whereas most economists had estimated NAIRU to be 5%-6% for the past several decades, the current thinking is that NAIRU may be closer to 4% or even lower. The Fed itself was beginning to reach this conclusion prior to the arrival of COVID when its preemptive interest-rate hikes (a response, in part, to low unemployment) caused a significant slowdown in economic growth. But more on this below.
With regard to its inflation mandate, the Fed has historically targeted a rate of 2%. However, the Fed recently made a fairly dramatic change to its approach to now incorporate a new concept called Average Inflation Targeting (AIT). Here’s how that goes: since the economy has been running at inflation rates well below the targeted 2% for many years, the central bank will now tolerate time periods (undefined in duration, but perhaps extended periods) during which inflation will be allowed to run above the targeted 2%. The goal of AIT is to arrive at a longer-term average of 2% rather than simply trying to hit a discrete target and remain there.
How does this new concept of inflation targeting dovetail with the new thinking on unemployment and the NAIRU? It all comes down to a model called the Phillips Curve. The Phillips Curve postulates that inflation rises as the unemployment rate falls. The problem with the Phillips Curve is that it has basically been discredited it recent times, as alluded to above. Prior to the arrival of COVID, the unemployment rate had been running as low as 3.8%, and yet inflation never really reached the Fed’s target of 2% on a sustainable basis. In fact, the Fed, anticipating higher inflation resulting from the low rate of unemployment, started to tighten its monetary policy (raise short-term interest rates and stop buying longer-term bonds) in 2015, and what happened? You guessed it. The economy swooned and the Fed quickly started to cut interest rates again. The lesson the Fed learned from this policy mistake is that low rates of unemployment may not be so inflationary after all. Fed members now wonder if it might be possible to sustain unemployment considerably below 4% without sparking undesirable levels of inflation. And while that question is currently moot with the unemployment rate far above that level, the experience just prior to COVID clearly informs the Fed’s actions and policy today.
We’ve all heard about the negative repercussions relating to the Fed’s extended periods of interest rate suppression. The risks and drawbacks, as I see them, are these: 1) asset bubbles that ultimately pop and cause heavy investment losses and instability in the financial markets; 2) a pulling forward of future demand; and perhaps most importantly 3) the encouragement of massive amounts of debt. All these risks are very real and will eventually cause big problems, but it’s clear the Fed sees them as manageable or at least of secondary concern when compared to the current weakness in the labor market. The Fed pretty clearly believes it can ignore debt and asset froth right now in a greater quest to reduce unemployment, raise middle-class incomes and reduce poverty and economic inequality.
But are there ancillary goals or side effects that the Fed is trying to accomplish by keeping the pedal to the metal? One is fairly obvious. The Fed is trying to spark inflation because it knows that the massive amount of debt that has been accumulated, especially by the federal government, can be managed much more easily if there is some inflation. Inflation generally can be expected to cause corporate revenues, personal incomes and government tax revenue to rise along with general price levels, which helps immensely in paying back fixed amounts of debt. Think of it this way: If you have a fixed-rate mortgage and your monthly payment is $2,000, wouldn’t that fixed payment be much easier to handle if you are getting annual pay raises of 5% instead of 1%?
In a recent conversation with former Richmond Fed President and good friend Jeff Lacker, I raised the possibility that we might be seeing additional mission creep out of the Fed. I said that in recent months various Fed members had raised the issue of climate change and its potential threat to the financial system. I asked Jeff if he thought it might be possible that today’s Fed, in its evaluation of the current level of “irrational exuberance” in the stock market, might have concluded that the extreme levels of market speculation in certain sectors, like renewable energy, might actually be a very positive side effect of the Fed’s sustained, ultra-loose monetary policy. I asked if, perhaps, the Fed might even be rooting for this process to continue as millions upon millions of fresh capital is being raised that will contribute heavily to the cause.
But Jeff roundly dismissed my suggestion. Any notion that the Fed’s voting members may be united in a secret ploy to solve the problem of climate change is just not realistic. The Fed’s membership likely has varying opinions on the subject, and there is likely no consensus on the adequacy of the Federal government’s initiatives to solve the problem. Instead, Jeff told me that the Fed’s overarching focus is the plight of the middle-class working family…period. Maximum employment, which is one of the Fed’s explicit mandates, means that, by definition, the labor market is tight. And wage growth is usually strongest when the labor market is tight because there aren’t several available prospective workers for each job opening. So, the Fed’s mandate of maximum employment will normally lead to both low unemployment and solid income gains for the middle class. This is the Fed’s primary objective.
On the inflation mandate, Jeff’s thoughts were also very insightful. He said that the inflation mandate is perceived by the Fed as more of a litmus test or scorecard for how forcefully and effectively the Fed is pursuing its primary objective of supporting the labor market: “The Fed is trying to spark inflation because when inflation is persistently below its announced target, even by a smidgen, it is vulnerable to accusations that it is not doing enough to reduce unemployment and improve the plight of workers. More broadly, the Fed’s entire stance, especially its forceful advocacy of further stimulus spending, stems from a desire to signal its strong alignment with concerns about income inequality, the plight of workers, and so on.”
It sure is good to have a few friends in high places to help me understand the inner workings of such a powerful organization. In my opinion, today’s level of intense media focus and round-the-clock financial news sometimes does more harm than good. The endless speculation about the Fed’s “real” motivations is usually a big distraction for investors, both novice and professional. It is always good to be reminded by people like Jeff that the Fed is staffed with incredible minds that have a deep and sincere desire to expand access to the American dream and raise living standards for all Americans.