MNI EXCLUSIVE-Fed Officials Fear Job Market 'Scarring'

Federal Reserve officials are worried the Covid-19 shock, which is devastating some sectors while bolstering others, will make this economic downturn especially prone to lasting labor market damage and require easier monetary policy for longer, current and former officials told MNI.

Job losses are hitting lower-wage workers disproportionately as the so-called "K-shaped" recovery slams services sectors in particular. Officials, already reassessing their policy response to a pandemic crisis which has proved longer-lived then initially expected, fear millions may struggle to find new positions which match their skills or circumstances, potentially feeding a spike in long-term unemployment reminiscent of the Great Recession. Other workers may end up so discouraged they drop out of the labor force permanently.

"That will make it much harder to restart economic activity when the economy starts to improve," Laura Velkamp, a Columbia Business School professor who sits on the New York Fed's economic advisory panel, told MNI. Job scarring "will depress output and investment substantially, and interest rates modestly, for decades to come," Veldkamp and co-authors wrote in a report presented to the New York Fed.

The Federal Reserve, whose new framework assigns greater weight to a broader range of socio-economic indicators, will be closely monitoring the labor force participation rate. Already depressed coming into this crisis, it cratered to an April low of 60.1% of the population from 63.4% in February. As of October, it remained at 61.7%.

Scarring risks becoming more widespread as firms go out of business and temporary layoffs become permanent, sources said. Pandemic disruption also threatens what Veldkamp calls "belief scarring"--where individuals' fears of another, similar shock inhibits investment and consumption.

New research from the Kansas City Fed builds on Veldkamp's findings, arguing that "the nature of the public health-induced downturn heightens concerns about lasting damage to labor markets" because of steep drops in participation.

PERMANENT SEPARATIONS

In their paper prepared for this year's Jackson Hole conference, Veldkamp and co-authors identified major long-term benefits from preventing bankruptcies or "permanent separation of labor and capital."

It was the fear of such an outcome, based in part on the experience of the 2008 financial crisis and the subsequent anemic expansion, that prompted the central bank to act early and forcefully on everything from slashing interest rates to launching new emergency credit facilities.

As he opened the door to future additions to quantitative easing after the Fed's meeting last week, Chair Jerome Powell told reporters fear of scarring was a key motivation for this early policy response. This is now being reassessed in light of a more protracted pandemic than initially hoped.

The urgency of the debate has been heightened by the lack of fiscal action in Congress. Many economists believe a second fiscal deal is crucial to sustaining any incipient recovery from such a deep recession.

The prospects for a large fiscal package remain unclear, despite electoral victory for Joe Biden, because control of the Senate still hangs in the balance with two Georgia races heading for run-offs.

The unemployment rate spiked to a post-depression peak of 14.7% in April and remains high at 7.9%.

That contrasts with the experience in European nations, where unemployment rose much less sharply because of job-retention arrangements and stronger social safety nets.

"The U.S. has adopted a very different approach to almost all European countries, including the UK," Jonathan Portes, ex-chief economist of the UK Cabinet, told MNI.

Portes expects this gap to have "persistent effects on the U.S. job market, noting that participation rates never fully recovered after the last slump."

In a speech last month, Fed Governor Lael Brainard warned "premature withdrawal of fiscal support would risk allowing recessionary dynamics to become entrenched, holding back employment and spending, increasing scarring from extended unemployment spells, leading more businesses to shutter, and ultimately harming productive capacity."