Short and sharp: A little bit of patience

Much of the market’s interest in the Federal Reserve’s (Fed) review of its monetary policy has focused on its embrace of average inflation targeting. While the overshooting part of the new framework is clearly of major significance, of equal importance is the Fed’s change to how it views the second part of its congressional mandate: achieving maximum employment.

The Fed is now aiming to eliminate “shortfalls” rather than “deviations” from maximum employment, and defines the maximum level of employment as a “broad-based and inclusive goal.” This subtle change implies that the Fed has a stronger appreciation for the benefits of a strong labour market, particularly for many in low- and moderate-income communities. And until the benefits of the economic recovery have been felt by all parts of society, the Fed will permit inflation to rise.

An uneven recovery

During the current quarter, U.S. GDP is set to return to pre-pandemic levels and the unemployment rate has dropped back from nearly 15% in April of last year to just 6% today, both marking a stunning recovery from the initial COVID-19 economic shock.

Behind those impressive numbers lies a murkier picture. By January 2021, the national unemployment rate had fallen to 6.7%, yet Federal Reserve staff analysis indicated that the unemployment rate for workers in the bottom quarter of wages was likely above 20%. Furthermore, if we adjust the March 6% headline unemployment rate for the decline in participation since February 2020 and the Bureau of Labor Statistics estimate of misclassification, the unemployment rate would in fact be closer to 9%, not far off the peak following the Global Financial Crisis.

Therefore, there is an argument to be made that the recovery from the pandemic hasn’t been as strong as the headline numbers suggest, nor as evenly distributed. Instead, as Fed Chairman Jerome Powell noted in the April FOMC meeting press conference, “the economic downturn has not fallen equally on all Americans, and those least able to shoulder the burden have been hardest hit. In particular, the high level of joblessness has been especially severe for lower-wage workers in the services sector, for women, and for African Americans and Hispanics.”

The Fed’s role in promoting inclusion

Over the past 10 years, fostering inclusive growth (growth that is both sustainable and broad-based in terms of employment opportunities) has moved higher up governments agendas and now, with evidence suggesting that racial and wage disparities in employment only start to close later in economic cycles, higher up for the Federal Reserve as well.

The economic expansion that prevailed before the pandemic was the longest on record and resulted in the U.S. unemployment rate falling to near-historic lows. Employment opportunities were created for many Americans who had been heading for a permanent exit from the labour force and, by early 2019, employers were hiring minority workers at the same rate as those of non-minority workers, narrowing long-standing unemployment gaps. This experience confirmed to the Fed that overheating the economy and extending the business cycle can result in a more broad-based and inclusive recovery.

A flatter Phillips Curve promotes patience

Today, the economic drawbacks of running the economy hot appear to have diminished. In the past, the relationship between unemployment and inflation, illustrated by the Phillips Curve, dictated that as unemployment falls, inflation rises—but this may no longer be the case. The sensitivity of inflation to tightening labour market conditions has diminished in recent decades as a result of technology advancement, globalization, and changing demographics, not to mention credible central bank policy.

With employment no longer as tightly linked to inflation, and if the potential benefits to low income and minority communities are significant, a low unemployment rate is not, by itself, a reason to tighten monetary policy.

Under the Fed’s new framework, it will consider a broader array of labour market statistics, including female labour force participation, minority unemployment and wage growth of low-income jobs in order to gauge when maximum employment has been reached.

Not only does this imply a greater commitment to an inclusive recovery, it also indicates that unless inflation significantly and persistently overshoots the 2% target. The Fed will wait before tightening policy. While the Fed has been steadfast in communicating its intentions in recent months, its focus on a broad and inclusive recovery in the labour market means that even in the face of rising inflation and falling unemployment, the Federal Reserve will continue to keep rates on hold through to 2023, thereby extending the supportive backdrop for risk assets.

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