MNI: Higher Inflation To Drive Fed To Redefine Full Employment

Federal Reserve officials could concede by mid-next year that unemployment and workforce participation rates may not recover to pre-pandemic levels, declaring the maximum employment objective of the Fed's dual mandate met and clearing the way for interest rates to lift off zero if inflation stays uncomfortably high, former senior officials and a regional Fed adviser told MNI.

Demand for workers has propelled job openings to record levels, leading to higher pay and a speedy recovery in the unemployment rate to below 5%. That's prompted a vocal minority of policymakers to argue that what slack there is in the labor market will soon be absorbed, despite the fact that some 5 million Americans have yet to return to work.

Continued high inflation next year could convince others to reassess their guideposts for maximum employment and begin normalizing rates as soon as the second half of 2022, the ex-officials said.

"Whether we're back at full employment or not is debatable. I'd be on the 'not' side but you can argue the other side. What's not debatable is inflation has gone quite high," former Fed Vice Chair Alan Blinder told MNI.

"The labor market will continue to tighten because of strong growth. The bottlenecks that I believe are the main cause of the resurgence of inflation are going to go away, but not that fast. So you'll have members of the FOMC starting to flip."

HANDS TIED

While the Fed would find it difficult to renege on last September's commitment to keep rates near zero until "labor market conditions have reached levels consistent with the Committee's assessments of maximum employment", it could still alter its interpretation of what that means, former Dallas Fed principal monetary policy advisor Evan Koenig told MNI.

More than half of those 5 million missing workers now count themselves as retired. The rest have dropped out due to concerns over health risks, child care or are reassessing their careers, and have not rushed back to work even after expanded federal unemployment benefits expired.

"Given the short-term health considerations and other constraints on participation, and that employers are having trouble finding people and having to offer bonuses and higher wages to attract workers, in that sense we're at a short-run concept of full employment," Koenig said.

As Covid worries recede and people's confidence improve, the labor supply shortages should unwind, and the definition of full employment will evolve, he added.

RETHINKING FULL EMPLOYMENT

Near-certain upward revisions to the FOMC's inflation forecasts over the next quarters will also force a rethink of what's attainable for the labor market, said former Fed Board research director David Wilcox.

The September SEP saw the unemployment rate dipping below its longer run rate by the end of next year and inflation dropping back to a benign 2.2%. "Inflation is mostly taking care of itself without any substantial restraint from monetary policy," according to that forecast. If that expectation doesn't bear out, the logical thing for the Fed to do is to reassess its definition of maximum employment, Wilcox said.

"They might simply conclude that lower readings on various metrics of labor utilization are attainable in the post-Covid world than previously thought," he added. That would then lead to a declaration that in fact they had met both legs of the dual mandate.

"How do you know, traditionally, when you've met the employment goal? When inflation starts rearing its ugly head," Blinder said. "Almost certainly when they're ready to raise rates, they will have met the maximum employment goal and inflation is too high."

As for the new framework's emphasis on a broad and inclusive interpretation of maximum employment, Cleveland Fed adviser Michael Weber told MNI last week the Fed is aware of the risk that raising rates too soon could hurt the most vulnerable parts of the labor market.

But, given elevated inflation, "At some point, what will happen is that this broad based inclusive growth mandate won't be as prominently discussed anymore and the discussion will be about overall labor market statistics," said Weber, a Chicago Booth School of Business professor.