The Federal Open Market Committee’s September 2022 Meeting and the Question of Whether the Fed Should Focus Only on Price Stability

The Federal Reserve building in Washington, DC. (Photo from the Wall Street Journal.)

In the Federal Reserve Act, Congress charged the Federal Reserve with conducting monetary policy so as to achieve both “maximum employment” and “stable prices.”  These two goals are referred to as the Fed’s dual mandate.  (We discuss the dual mandate in Macroeconomics, Chapter 15, Section 15.1, Economics, Chapter 25, Section 25.1, and Money, Banking, and the Financial System, Chapter 15, Section 15.1.) Accordingly, when Fed chairs give their semiannual Monetary Policy Reports to Congress, they reaffirm that they are acting consistently with the dual mandate. For example, when testifying before the U.S. Senate Committee on Banking, Housing, and Urban Affairs in June 2022, Fed Chair Jerome Powell stated that: “The Fed’s monetary policy actions are guided by our mandate to promote maximum employment and stable prices for the American people.”

Despite statements of that kind, some economists argue that in practice during some periods the Fed’s policymaking Federal Open Market Committee (FOMC) acts as if it were more concerned with one of the two mandates. In particular, in the decades following the Great Inflation of the 1970s, FOMC members appear to have put more emphasis on price stability than on maximum employment. These economists argue that during these years, FOMC members were typically reluctant to pursue a monetary policy sufficiently expansionary to lead to maximum employment if the result would be to cause the inflation rate to rise above the Fed’s target of an annual target of 2 percent. (Although the Fed didn’t announce a formal inflation target of 2 percent until 2012, the FOMC agreed to set a 2 percent inflation target in 1996, although they didn’t publicly announce at the time. Implicitly, the FOMC had been acting as if it had a 2 percent target since at least the mid–1980s.)

In July 2019, the FOMC responded to a slowdown in economic growth in late 2018 and early 2019 but cutting its target for the federal funds rate. It made further cuts to the target rate in September and October 2019. These cuts helped push the unemployment rate to low levels even as the inflation rate remained below the Fed’s 2 percent target. The failure of inflation to increase despite the unemployment rate falling to low levels, provides background to the new monetary policy strategy the Fed announced in August 2020. The new monetary policy, in effect, abandoned the Fed’s previous policy of attempting to preempt a rise in the inflation rate by raising the target for the federal funds rate whenever data on unemployment and real GDP growth indicated that inflation was likely to rise. (We discussed aspects of the Fed’s new monetary policy in previous blog posts, including here, here, and here.)

In particular, the FOMC would no longer see the natural rate of unemployment as the maximum level of employment—which Congress has mandated the Fed to achieve—and, therefore, wouldn’t necessarily begin increasing its target for the federal funds rate when the unemployment rate dropped by below the natural rate. As Fed Chair Powell explained at the time, “the maximum level of employment is not directly measurable and [it] changes over time for reasons unrelated to monetary policy. The significant shifts in estimates of the natural rate of unemployment over the past decade reinforce this point.”

Many economists interpreted the Fed’s new monetary strategy and the remarks that FOMC members made concerning the strategy as an indication that the Fed had turned from focusing on the inflation rate to focusing on unemployment. Of course, given that Congress has mandated the Fed to achieve both stable prices and maximum employment, neither the Fed chair nor other members of the FOMC can state directly that they are focusing on one mandate more than the other. 

The sharp acceleration in inflation that began in the spring of 2021 and continued into the fall of 2022 (shown in the following figure) has caused members of the FOMC to speak more forcefully about the need for monetary policy to bring inflation back to the Fed’s target rate of 2 percent. For example, in a speech at the Federal Reserve Bank of Kansas City’s annual monetary policy conference held in Jackson Hole, Wyoming, Fed Chair Powell spoke very directly: “The Federal Open Market Committee’s (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal.” According to an article in the Wall Street Journal, Powell had originally planned a longer speech discussing broader issues concerning monetary policy and the state of the economy—typical of the speeches that Fed chairs give at this conference—before deciding to deliver a short speech focused directly on inflation.

Members of the FOMC were concerned that a prolonged period of high inflation rates might lead workers, firms, and investors to no longer expect that the inflation rate would return to 2 percent in the near future. If the expected inflation rate were to increase, the U.S. economy might enter a wage–price spiral in which high inflation rates would lead workers to push for higher wages, which, in turn, would increase firms’ labor costs, leading them to raise prices further, in response to which workers would push for even higher wages, and so on. (We discuss the concept of a wage–price spiral in earlier blog posts here and here.)

With Powell noting in his Jackson Hole speech that the Fed would be willing to run the risk of pushing the economy into a recession if that was required to bring down the inflation rate, it seemed clear that the Fed was giving priority to its mandate for price stability over its mandate for maximum employment. An article in the Wall Street Journal quoted Richard Clarida, who served on the Fed’s Board of Governors from September 2018 until January 2022, as arguing that: “Until inflation comes down a lot, the Fed is really a single mandate central bank.”

This view was reinforced by the FOMC’s meeting on September 21, 2022 at which it raised its target for the federal funds rate by 0.75 percentage points to a range of 3 to 3.25 percent. The median projection of FOMC members was that the target rate would increase to 4.4 percent by the end of 2022, up a full percentage point from the median projection at the FOMC’s June 2022 meeting. The negative reaction of the stock market to the announcement of the FOMC’s decision is an indication that the Fed is pursuing a more contractionary monetary policy than many observers had expected. (We discuss the relationship between stock prices and economic news in this blog post.)

Some economists and policymakers have raised a broader issue concerning the Fed’s mandate: Should Congress amend the Federal Reserve Act to give the Fed the single mandate of achieving price stability? As we’ve already noted, one interpretation of the FOMC’s actions from the mid–1980s until 2019 is that it was already implicitly acting as if price stability were a more important goal than maximum employment. Or as Stanford economist John Cochrane has put it, the Fed was following “its main mandate, which is to ensure price stability.”

The main argument for the Fed having price stability as its only mandate is that most economists believe that in the long run, the Fed can affect the inflation rate but not the level of potential real GDP or the level of employment. In the long run, real GDP is equal to potential GDP, which is determined by the quantity of workers, the capital stock—including factories, office buildings, machinery and equipment, and software—and the available technology. (We discuss this point in Macroeconomics, Chapter 13, Section 13.2 and in Economics, Chapter 23, Section 23.2.) Congress and the president can use fiscal policy to affect potential GDP by, for example, changing the tax code to increase the profitability of investment, thereby increasing the capital stock, or by subsidizing apprentice programs or taking other steps to increase the labor supply. But most economists believe that the Fed lacks the tools to achieve those results. 

Economists who support the idea of a single mandate argue that the Fed would be better off focusing on an economic variable they can control in the long run—the inflation rate—rather than on economic variables they can’t control—potential GDP and employment. In addition, these economists point out that some foreign central banks have a single mandate to achieve price stability. These central banks include the European Central Bank, the Bank of Japan, and the Reserve Bank of New Zealand.

Economists and policymakers who oppose having Congress revise the Federal Reserve Act to give the Fed the single mandate to achieve price stability raise several points. First, they note that monetary policy can affect the level of real GDP and employment in the short run. Particularly when the U.S. economy is in a severe recession, the Fed can speed the return to full employment by undertaking an expansionary policy. If maximum employment were no longer part of the Fed’s mandate, the FOMC might be less likely to use policy to increase the pace of economic recovery, thereby avoiding some unemployment.

Second, those opposed to the Fed having single mandate argue that the Fed was overly focused on inflation during some of the period between the mid–1980s and 2019. They argue that the result was unnecessarily low levels of employment during those years. Giving the Fed a single mandate for price stability might make periods of low employment more likely.

Finally, because over the years many members of Congress have stated that the Fed should focus more on maximum employment than price stability, in practical terms it’s unlikely that the Federal Reserve Act will be amended to give the Fed the single mandate of price stability.

In the end, the willingness of Congress to amend the Federal Reserve Act, as it has done many times since initial passage in 1914, depends on the performance of the U.S. economy and the U.S. financial system. It’s possible that if the high inflation rates of 2021–2022 were to persist into 2023 or beyond, Congress might revise the Federal Reserve Act to change the Fed’s approach to fighting inflation either by giving the Fed a single mandate for price stability or in some other way. 

Sources: Board of Governors of the Federal Reserve System, “Federal Reserve Issues FOMC Statement,” federalreserve.gov, September 21, 2022; Board of Governors of the Federal Reserve System, “Summary of Economic Projections,” federalreserve.gov, September 21, 2022; Nick Timiraos, “Jerome Powell’s Inflation Whisperer: Paul Volcker,” Wall Street Journal, September 19, 2022; Matthew Boesler and Craig Torres, “Powell Talks Tough, Warning Rates Are Going to Stay High for Some Time,” bloomberg.com, August 26, 2022; Jerome H. Powell, “Semiannual Monetary Policy Report to the Congress,” June 22, 2022, federalreserve.gov; Jerome H. Powell, “Monetary Policy and Price Stability,” speech delivered at “Reassessing Constraints on the Economy and Policy,” an economic policy symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, federalreserve.gov, August 26, 2022; John H. Cochrane, “Why Isn’t the Fed Doing its Job?” project-syndicate.org, January 19, 2022; Board of Governors of the Federal Reserve System, “Minutes of the Federal Open Market Committee Meeting on July 2–3, 1996,” federalreserve.gov; and Federal Reserve Bank of St. Louis.

How Do We Know When the Economy Is at Maximum Employment?

Photo from the Wall Street Journal

According to the Federal Reserve Act, the Fed must conduct monetary policy “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Neither “maximum employment” nor “stable prices” are defined in the act.

The Fed has interpreted “stable prices” to mean a low rate of inflation. Since 2012, the Fed has had an explicit inflation target of 2 percent. When the Fed announced its new monetary policy strategy in August 2020, it modified its inflation target by stating that it would attempt to achieve an average inflation rate of 2 percent over time. As Fed Chair Jerome Powell stated: “Our approach can be described as a flexible form of average inflation targeting.” (Note that although the consumer price index (CPI) is the focus of many media stories on inflation, the Fed’s preferred measure of inflation is changes in the core personal consumption expenditures (PCE) price index. The PCE is a broader measure of the price level than is the CPI because it includes the prices of all the goods and services included in consumption category of GDP. “Core” means that the index excludes food and energy prices. For a further discussion see, Economics, Chapter 25, Section 15.5 and Macroeconomics, Chapter 15, Section 15.5.) 

There is more ambiguity about how to determine whether the economy is at maximum employment. For many years, a majority of members of the Federal Open Market Committee (FOMC) focused on the natural rate of unemployment (also called the non-accelerating rate of unemployment (NAIRU)) as the best gauge of when the U.S. economy had attained maximum employment. The lesson many economists and policymakers had taken from the experience of the Great Inflation that lasted from the late 1960s to the early 1980s was if the unemployment rate was persistently below the natural rate of unemployment, inflation would begin to accelerate. Because monetary policy affects the economy with a lag, many policymakers believed it was important for the Fed to react before inflation begins to significantly increase and a higher inflation rate becomes embedded in the economy.

At least until the end of 2018, speeches and other statements by some members of the FOMC indicated that they continued to believe that the Fed should pay close attention to the relationship between the natural rate of unemployment and the actual rate of unemployment. But by that time some members of the FOMC had concluded that their decision to begin raising the target for the federal funds rate in December 2015 and continuing raising it through December 2018 may have been a mistake because their forecasts of the natural rate of unemployment may have been too high. For instance, Atlanta Fed President Raphael Bostic noted in a speech that: “If estimates of the NAIRU are actually too conservative, as many would argue they have been … unemployment could have averaged one to two percentage points lower” than it actually did.

Accordingly, when the Fed announced its new monetary policy strategy in August 2020, it indicated that it would consider a wider range of data—such as the employment-population ratio—when determining whether the labor market had reached maximum employment. At the time, Fed Chair Powell noted that: “the maximum level of employment is not directly measurable and [it] changes over time for reasons unrelated to monetary policy. The significant shifts in estimates of the natural rate of unemployment over the past decade reinforce this point.”

As the economy recovered from the effects of the Covid-19 pandemic, the Fed faced particular difficulty in assessing the state of the labor market. Some labor market indicators appeared to show that the economy was close to maximum employment while other indicators showed that the labor market recovery was not complete. For instance, in December 2021, the unemployment rate was 3.9 percent, slightly below the average of the FOMC members estimates of the natural rate of unemployment, which was 4.0 percent. Similarly, as the first figure below shows, job vacancy rates were very high at the end of 2021. (The BLS calculates job vacancy rates, also called job opening rates, by dividing the number of unfilled job openings by the sum of total employment plus job openings.) As the second figure below shows, job quit rates were also unusually high, indicating that workers saw the job market as being tight enough that if they quit their current job they could find easily another job. (The BLS calculates job quit rates by dividing the number of people quitting jobs by total employment.) By those measures, the labor market seemed close to maximum employment.

But as the first figure below shows, total employment in December 2021 was still 3.5 million below its level of early 2020, just before the U.S. economy began to experience the effects of the pandemic. Some of the decline in employment can be accounted for by older workers retiring, but as the second figure below indicates, employment of prime-age workers (those between the ages of 25 and 54), had not recovered to pre-pandemic levels. 

How to reconcile these conflicting labor market indicators? In January 2022, Fed Chair Powell testified before the Senate Banking Committee as the Senate considered his nomination for a second four-year term as chair. In discussing the state of the economy he offered the opinion that: “We’re very rapidly approaching or at maximum employment.” He noted that inflation as measured by changes in the CPI had been running above 5 percent since June 2021: “If these high levels of inflation get entrenched in our economy, and in people’s thinking, then inevitably that will lead to much tighter monetary policy from us, and it could lead to a recession.” In that sense, “high inflation is a severe threat to the achievement of maximum employment.”

At the time of Powell’s testimony, the FOMC had already announced that it was moving to a less expansionary monetary policy by reducing its purchases of Treasury bonds and mortgage-backed securities and by increasing its target for the federal funds rate in the near future. He argued that these actions would help the Fed achieve its dual mandate by reducing the inflation rate, thereby heading off the need for larger increases in the federal funds rate that might trigger a recession. Avoiding a recession would help achieve the goal of maximum employment.

Powell’s remarks did not make explicit which labor market indicators the Fed would focus on in determining whether the goal of maximum employment had been obtained. It did make clear that the Fed’s new policy of average inflation targeting did not mean that the Fed would accept inflation rates as high as those of the second half of 2021 without raising its target for the federal funds rate. In that sense, the Fed’s monetary policy of 2022 seemed consistent with its decades-long commitment to heading off increases in inflation before they lead to a significant increase in the inflation rate expected by households, businesses, and investors. 

Note: For a discussion of the background to Fed policy, see Economics, Chapter 25, Section 25.5 and Chapter 27, Section 17.4, and Macroeconomics, Chapter 15, Section 15.5 and Chapter 17, Section 17.4.

Sources: Jeanna Smialek, “Jerome Powell Says the Fed is Prepared to Raise Rates to Tame Inflation,” New York Times, January 11, 2022; Nick Timiraos, “Fed’s Powell Says Economy No Longer Needs Aggressive Stimulus,” Wall Street Journal, January 11, 2022; and Federal Open Market Committee, “Meeting Calendars, Statements, and Minutes,” federalreserve.gov, January 5, 2022.

Solved Problem: The Fed’s Policy Dilemma

Supports:  Macroneconomics Chapter 15, Section 15.3; Economics Chapter 25, Section 25.3; and Essentials of Economics Chapter 17, Sections 17.3.

Solved Problem: The Fed’s Policy Dilemma

   In the fall of 2021, the inflation rate was at its highest level since 2008. The unemployment rate was above 5 percent, which was much lower than in the spring of 2020, but still well above its level of early 2020 before the Covid-19 pandemic. In testifying before Congress, Fed Chair Jerome Powell stated that he believed the high inflation rate was transitory and in the longer run “inflation is expected to drop back toward our longer-run 2 percent goal.”

But Powell also stated that if inflation continued to remain high the Fed would face a policy dilemma. “Almost all of the time, inflation is low when unemployment is high, so interest rates work on both problems.” But in contrast, in the fall of 2021 both the unemployment and inflation rates were high: “That’s the very difficult situation we find ourselves in.”

a. Briefly explain what Powell meant by saying that almost all of the time “interest rates work on both problems.”

b. Why did macroeconomic conditions in the fall of 2021 present Fed policymakers with a “very difficult” situation?

Source: Kate Davidson and Nick Timiraos, “Powell Says Fed Faces ‘Difficult Trade-Off’ if Inflation Doesn’t Moderate,” Wall Street Journal, September 30, 2021; and Chair Jerome H. Powell, “Testimony Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Washington, D.C.” September 28, 2021, federalreserve. gov..

Solving the Problem

Step 1:   Review the chapter material. This problem is about the policy situation the Fed faces when the unemployment and inflation rates are both high, so you may want to review Chapter 15, Section 15.3, “Monetary Policy and Economic Activity,” and the discussion of staflation, including Figure 13.7, in Chapter 13, Section 13.3, “Macroeconomic Equilibrium in the Long Run and the Short Run.”

Step 2:   Explain what Powell meant by “interest rates work on both problems.” We’ve seen that in the typical recession the unemployment rate increases while the inflation rate decreases. We’ve also seen that if the economy is above potential GDP, the unemployment rate is very low but the inflation rate increases. (To review these facts, see Chapter 10, Section 10.3 “The Business Cycle.”) The Fed uses changes in its target for the federal funds rate to affect the level of real GDP and the price level, as it attempts to hit its policy goals of high employment and price stability.

So “almost all of the time,” the Fed can use interest rates–changes in the target for the federal funds rate–to work on the problems of high unemployment and high inflation–depending on which is occuring during a particular period.

Step 3: Explain why macroeconomic conditions in the fall of 2021 presented Fed policymakers with a “very difficult” situation. As Powell observes, “almost all the time” Fed policy is focused on reducing either high unemployment or high inflation, but not both. As we note in Chapter 13, Section 13.3, economists refer to a situation when the unemployment and inflations rates are both high at the same time as a period of stagflation. If the inflation rate is high, then expansionary monetary policy–a low target for the federal funds rate–will reduce the unemployment rate but make an already high inflation rate even higher. Similarly, if the unemployment rate is high, then contractionary monetary policy–a high target for the federal funds rate–will reduce the inflation rate but make an already high unemploument rate even higher. A very difficult policy dilemma for the Fed!

How did Fed policymakers expect to resolve this difficulty? In his testimony, Powell explained that he believed that the high inflation rate the U.S. economy was experiencing during the fall of 2021 was transitory and would begin to decline once the supply problems caused by the Covid-19 pandemic were resolved in the coming months. Referring to the supply problems he noted that “These aren’t things that we [the Fed] can control.” Therefore, the Fed did not intend to use policy to address the high inflation rate and could continue to pursue an expansionary monetary policy to push the labor market back to full employment.

Glenn Is Interviewed by the Financial Times

The Financial Times recently interviewed Glenn. Here is an edited version. The full interview can be found here.

Financial Times (Gillian Tett, editor-at-large for the United States): Gross domestic product data show that the economy is rebounding very fast from the pandemic; the Federal Reserve just said that it doesn’t intend to raise rates any time soon; and President Joe Biden has pledged a massive fiscal package. So what is your forecast for the American economy?

Glenn:  Re-opening as the virus recedes would always lead to a very significant pop in GDP growth. So the near-term is not really the big question. There will certainly be a transitory increase in inflation. But I think the Fed on balance is correct, that boost is likely to be transitory. My worry is when I hear the Fed talk, as its chair Jay Powell has done, about wanting to watch for labor market “re-healing” to finish. The problem in the labor market is [largely] structural. Just running the economy hot by the Fed doesn’t fix that.

On fiscal policy, this is not just a “boost”.… The American Rescue Plan was intended as stimulus. But the American Jobs Act, the American Families Plan, those are really a remaking of the size of government. It has to be paid for and arithmetically can’t be paid for by taxes on the rich. There’s just not enough there. So the honest conversation with the American people is a matter of public choice: if you want a big government that does what President Biden wants [it to do], you’ll have to pay for it. 

GT: How confident are you that inflation pressures are transitory?

GH: One can never be completely confident, but I think if the Fed had a clearer policy story I could be confident that commodity price increases are transitory. What worries me is the Fed thinking it can lean against structural changes in the labor market with monetary policy. One might worry a bit about inflation risks in the long-term—some of the structural headwinds against inflation to do with demography and growth in the emerging world, particularly in China, are going away. 

GT: Do you think that the Fed should be indicating that it’s willing to raise rates if inflation rises?

GH: I think the Fed is unlikely to do that. [But] one of the reasons you are seeing implied volatility in rates and credit markets so high relative to equities, is the fear in the bond market that, maybe, the Fed is saying one thing but if backed into the corner could do another. Remember that the Fed bought around half of Treasury issues last year, and owns 40 per cent of all of the outstanding 10-year plus maturity treasuries, so the Fed’s thoughts there, which aren’t really clear to the bond market, are very, very important. 

GT: Larry Summers has said this is way too much [stimulus], way too fast and will create inflation risks. You and Larry don’t often agree, but would you agree on this? 

GH: I would agree on the risk, but it’s [not] the problem that is worrying me the most. What worries me even more is [in trying to] create a government that large . . .  if you want a government that does those things, tax burdens will have to be higher.

If you look at the math on the tax burden, the [proposed] corporate tax increase or capital gains tax increase are not remotely large enough. The other structural thing that worries me is that I do see productivity reductions and investment reductions as a result of these large tax increases. 

GT: Biden said if you are earning less than $400,000 a year you will not see your taxes go up. 

GH: Well, it’s just not true, [neither] in the near-term [nor] the long-term. Take the corporate tax. Many economists have concluded that much of the burden of the corporate tax is borne by workers. In the 1970s and early 1980s, we thought it was capital that bore the burden of the corporate taxes. [But] that is not what economists believe today. So you simply cannot say that people who make less than $400,000 aren’t going to bear a part of the burden of the tax. 

Likewise with capital gains, the president says: “I’m only going after 0.3 per cent of taxpayers,” meaning [those] that make more than a million dollars a year and have capital gains. But those individuals don’t have 0.3 per cent of the capital gains—they likely have the bulk of them. So if there are any effects on risk-taking, on saving and investment, the [risks] are very large.

Those effects are borne by the economy, not by the top 0.3 per cent …. And in the longer term … if you look at the budget math here, there’s going to be a large revenue hole. Somebody has to pay for it. 

GT: Well, what about that “somebody” being companies? 

GH: Let’s put the tax changes into two buckets. On the rates, I don’t think we want to go as high as the president is proposing, certainly not back to the old rates. On the base, president Biden is proposing a tax increase by base broadening—it’s a very, very big change. I expect companies will acknowledge they need to pay some minimum level, but the math isn’t going to add up.

GT: What about taxes under the guise of climate change action, such as a fuel tax or value added tax?

GH: I think it’s a great idea. For years I have supported a carbon tax because I do believe that it is one of the best ways to deal with climate change. I’m very skeptical of subsidies in green things but if you put a price on carbon, businesspeople will rush around and innovate and do it efficiently and it does not have to be regressive .…

About [a value-added tax] VAT—there is no question that if we want the government President Biden is suggesting, you absolutely have to have a VAT.

European states that have much bigger [state sectors] than the American state as a share of GDP are not financed with taxes on capital. In fact, in many European countries capital taxes are lower than they are in the United States. They’re financed by consumption taxes [such as the VAT]. 

GT: Why do you think Biden’s package is undermining productivity? 

GH: Let me just take one step back. Some discussions of secular stagnation come from insufficient aggregate demand. Another school of thought thinks that structurally we have a problem with productivity growth, in terms of the supply side of the economy and the economy’s potential to grow. That is where I’m coming from. The tax plans are definitely anti-investment, as the lack of capital deepening explains low productivity growth and capital gains tax increases can affect risk-taking. There’s certainly nothing to enhance productivity [in Biden’s plans] and a lot to discourage productivity. 

It is not just the tax policy. I worry about a monetary policy that could lead to zombification of firms—an environment of very low interest rates that sustain low-productivity firms. To President Biden’s credit, pieces of what he’s proposing that are true infrastructure could, in fact, raise productivity, but that is a small part of what he’s actually calling infrastructure. 

GT: Are you concerned about a future debt crisis?

GH: Well, we are the reserve currency country, and we are borrowing in our currency, so I think a slow and steady malaise is more likely. To give a practical example, the Medicare trust fund could run out of money within a year or so, social security within five or so years. That will force discussions in Washington as to whether the public may wish to have a government this size. 

GT: So you don’t expect a debt crisis per se because of the reserve currency status?

GH: [Not] at the moment.

GT: Should Republicans be co-operating to create a bipartisan bill? 

GH: You could get bipartisan support for a new “GI bill” to prepare workers to adjust from the Covid world. For example, support in community colleges.

I’m not talking about free community college but supply side support—increasing their capacity to train people. Where you won’t get bipartisan support is [for] the notion that we need to move away from a work-supported social insurance system to a broader cradle-to-grave safety net.

The administration really fuzzed that up by calling it an infrastructure bill. Infrastructure doesn’t have to be just roads and bridges and airports—it could be broadband. But not healthcare. 

GT: Are childcare support and elderly support part of “infrastructure”?

GH: No—those are social spending. 

GT: One of the interesting ways you frame this debate is with the contrast between Keynes and Hayek, i.e. whether you’re trying to prop up the current system or encourage more rapid transformation. What do you mean?

GH: You could think of Covid [in terms of] a Keynesian response — we have a collapse in demand. The Keynesian response is not fanciful. But Hayek would say the new world after Covid isn’t going to look like the old world, so why support every single business? Both are right. We did a good job in policy on the Keynesian part. [But] we’ve done less well [thinking about Hayek]. 

GT: What do you think about Larry Summer’s concept of secular stagnation? 

GH: There’s a scene in Dickens’ A Christmas Carol, when Scrooge asks, [something like] “are these the shadows of things that are or might be?”. I feel the same way about Bob Gordon’s descriptions of the American economy — Larry and Bob are talking about the shadows of things that could be if we have bad enough public policy, going back to the anti-productivity story. But I don’t think they’re inevitable. 

Every businessperson with whom I speak is pretty optimistic about the technology frontier in productivity. If there’s a reason for pessimism, it’s more about the political system’s ability and willingness to let that productivity growth [run free].

GT: Do you think that the Republican party knows what it stands for with economics?

GH: … [An] approach Republicans could take is to go past the neoliberalism to liberalism (with a small L), to Adam Smith. He was anti-mercantilist—that’s what got him angry in The Wealth of Nations—and he was very interested in the ability of everybody in the economy to compete.

So a new Republican agenda might do more to help people compete—that sounds more like Lincoln, or like Roosevelt’s GI bill. In that lies a new agenda. But I don’t see the party really moving in that direction. 

GT: What about the second book of Smith’s, The Theory of Moral Sentiments?

GH: Smith referred to “mutual sympathy”, which today we would call empathy. Forward-leaning businesspeople and business leaders think that way. I don’t see [the environmental, social, and governance] ESG [approach to investing] as somehow an enemy of shareholders—this isn’t Milton Friedman versus socialism—it’s more a matter of what really is in the long-term interest of the firm.

Remember, Smith railed against the British East India Company, which he thought of as a cancer. He thought you had to be very careful in the social framing of corporations. Businesspeople today need to understand the corporate structure is a social gift. In fact, capitalism is a social gift. If the public doesn’t want it, it won’t happen. 

GT: I have a book coming out in a few weeks’ time that stresses this social and cultural aspect of business and finance and economics, and argues that business leaders need to move beyond tunnel vision to use lateral vision. Do you agree with this? 

GH: Yes. When I teach students political economy, I remind them that great thinkers like a Friedman or Hayek or Smith wrote [for] the times in which they lived. Friedman and Hayek were writing in response to a very slovenly and inefficient corporatist economic system and were horrified by fascism. If Ronald Reagan were with us today, I don’t think he would be the 1980s Ronald Reagan. If Friedman and Hayek were with us today, they might have a different view. Context shifts.

GT: Friedman was also operating when people assumed that they could outsource the difficult social decisions to government and when there wasn’t radical transparency and customers, clients and employees couldn’t see exactly what firms were doing. Does that matter?

GH: Yes. If Friedman were here he might correctly remind us that there are big social externalities no one company can fix. But there is no reason businesspeople can’t be leaders. When the Marshall Plan was passed, that was not because Congress in its great wisdom decided to do something. It was because the business community came together and said: “Good Lord, we are going to have communism in western Europe and what’s that going to do to our economic system?” They pushed Congress. I understand that [today business is] afraid. But it’s not an excuse not to act. At many companies, their own employees are going to put pressure [on them to act]. 

GT: You are starting to see a level of company collaboration which was unimaginable when we had Thatcherism and Reaganism. Will this last? 

GH: I do [think so] and Hayek would have celebrated this co-ordinated response because it bubbled up from the bottom. If you compare the production of vaccines, which was largely a private-sector activity, to the distribution of vaccines, which was more a public-sector activity, I think we know which one seemed to work better.

There are things that could help that—imagine if Biden put applied research centers all around the country that were linked with universities. That might help companies fix localities, as well as solving big problems like vaccines. 

GT: Are you concerned that we have an ESG bubble?

GH: I am, in several aspects. We are running the risk of industrial policy and rent seeking, with just subsidizing “green things.” I also worry about how CEOs can deal with this—you don’t want the CEO spending half of his or her day responding to social concerns.

GT: What about protectionism? Can the Republicans present an alternative voice on this? 

GH: I hope so, but I’m not sure. Like almost all economists … I believe in free trade. So why is something that is obvious in Econ 101 not so popular with the public?

I think for two reasons. One is whenever your Econ 101 professor talked about the gains from trade, he or she always [had] the idea that there would be losers, but compensation would somehow occur—and it hasn’t.

[Second] free trade is one of those examples, like the old classical gold standard, of a system that’s outside-in. You have to sign up for the rules of the game and then you just adjust. I think we need to go back to a period that says, look, we do need to understand domestic constituencies. That could mean much more support for training, it could be wage insurance, it could be lots of things rather than just saying free trade. 

GT: So it’s about trying to talk about free trade with both parts of Adam Smith. 

GH: Yes, exactly. Even Smith, who was the champion for openness, would not have countenanced whole areas just being left behind. Smith talked a lot about places—he said something like a man is a sort of luggage that’s hard to move, meaning you really have to look after places, not just jobs . . . its culture. 

GT: Hey, anthropology can mingle with economics! 

GH: Exactly—two social sciences, peas in a pod. 

GT: So what’s happening to the economics profession? With issues like [the debate around Larry Summers’ criticism of Biden’s policies] are we seeing a tribal warfare break out between economists? Is there a rethink of economics? Is Biden moving away from them?

GH: Well, let me start with some good news: the young stars in the [economics] profession today tend to be people who are talking about big problems with new tools and techniques, ranging from development to monetary policy to labor markets. I think that’s entirely healthy. 

I think the government needs people who have big macro views [too]. If I were in Janet Yellen’s shoes, I’d want to be talking to economists who could continue to give me that perspective, but also get micro perspectives from labor and financial markets. So there needn’t be a war. [But] I do worry from the way the Biden administration is talking about policies that economists just aren’t very involved at all. That’s not the first administration I’ve seen that happen—but it is a concern for the economics profession. 

Deciphering the April Employment Report

On Friday May 7, 2021, the Bureau of Labor Statistics (BLS) released its monthly “Employment Situation Report.”  The BLS estimated that nonfarm payroll employment had increased by 266,000 from March to April. The average forecast of the Wall Street Journal’s panel of economists was for a much higher increase in employment of  1 million. The unemployment rate increased from 6.0% to 6.1%, rather than falling to 5.8% as economists had forecast.  

Keep in mind that employment data is subject to revisions. What does this employment report tell us about the state of the economy and the state of the labor market?  First, it’s always worth remembering that the BLS revises its employment estimates at least three times in subsequent months as more complete data become available. (The unemployment rate estimates are calculated in a separate survey of households and are not revised other than as seasonal adjustment factors change.)

Employment data gathered during and immediately after a recession are particularly subject to large revisions. In the principles textbook, Chapter 19, Section 19.1 includes a discussion of the substantial revisions the BLS made to its initial employment estimates during the 2007–2009 recession.  Today’s report noted that the increase in employment from February to March, which had originally been reported as 916,000 had been revised downward to 770,000.

Explaining the slow increase in employment. So, the estimated employment increase the BLS reported today may well end up being revised upward. But the revisions will almost certainly leave the increase far short of the forecast increase of 1 million.  We can discuss two types of explanations for this relatively disappointing employment increase: 1) factors affecting the demand for labor, and 2) factors affecting the supply of labor.

The demand for labor.  During the recovery from a typical recession, increases in labor demand may lag behind increases in production, limiting employment increases and causing temporary increases in the unemployment rate.  Employers may be reluctant to hire more workers if the employers are uncertain that the increase in demand for their products will be maintained. During a recession, firms also typically reduce employment by less than they reduce output because searching for workers during a recovery is costly and because they may fear that if they lay off their most productive workers, these workers may accept jobs at competing firms. As a result, during the early months of a recovery, firms are in position to increase output by more than they increase employment. That this outcome occurred during the first months of 2021 is indicated by the fact that productivity increased 5.4% during the first quarter of 2021, as firms increased output by 8.4% but hours worked by only 2.9%.

The recession caused by the pandemic was unusual in that many businesses decreased their supply of goods and services not because of a decline in consumer demand but because of government social distancing requirements. During March 2021, as more people became vaccinated against Covid-19, state and local governments in many areas of the country were relaxing or eliminating these requirements. But upsurges in infection in some areas slowed this process and may also have made consumers reluctant to shop at stores or attend movie theaters even where such activities were not restricted. Finally, partly due to the pandemic, some U.S. manufacturers were having trouble receiving deliveries of intermediate goods. In particular, automobile companies had to reduce production or close some factories because of the difficulty of obtaining computer chips. As a result, during April 2021, employment declined in the motor vehicle and parts industry despite strong consumer demand for cars and light trucks.

The supply of labor. In the weeks leading up to the release of employment report, the media published many articles focusing on firms that were having difficulty hiring workers. BLS data for February 2021 (the most recent month with available data) showed that the estimated number of job opening nationwide was actually 5% higher than in February 2020, the last month before the pandemic.

That employment grew slowly despite a large number of available jobs may be an indication that labor supply had declined relative to the situation before the pandemic. That is, fewer people were willing to work at any given wage than a year earlier. There are several related reasons that the labor supply curve may have shifted: 1) Many K-12 schools were still conducting instruction either wholly or partially online making it more difficult for parents of school-age children to accept work outside the home; 2) although vaccinations had become widely available, some people were still hesitant to be in close proximity to other people as is required in many jobs; and 3) under the American Rescue Plan Act proposed by President Biden and passed by Congress in March 2021, many unemployed workers were eligible for an additional $300-per-week federal payment on top of their normal state unemployment insurance payment. These expanded unemployment benefits were scheduled to end September 2021. In the case of some low-wage workers, their total unemployment payment during April was greater than the wage they would have earned if employed.

These three factors affecting labor supply were potentially interrelated in that the expanded unemployment insurance benefits provided the financial means that allowed some workers to remain unemployed so that they could be home with their children or so that they could avoid a work situation that they believed exposed them to the risk of contracting Covid-19.

That at least some firms were having difficulty hiring workers seemed confirmed by the fact that average weekly hours worked steadily increased from February through April, indicating that employers were asking their existing employees to work longer hours. 

Summary. It’s never a good idea to draw firm conclusions about the state of the economy from one month’s employment report. That observation is particularly true in this case because April 2021 was a period of continuing transition in the U.S. economy as vaccination rates increased, infection rates declined, and government restrictions on business operations were relaxed. All of these factors made it likely that during the following months more businesses would be able to resume normal operations, increasing the demand for labor.

In addition, by the fall, the factors affecting labor supply may have largely been resolved as most children return to full-time on-site schooling, increased vaccination rates reduce fears of infection, and the supplementary unemployment benefits end.

The three figures below show: 1) total nonfarm private employment; 2) the employment-population ratio for workers aged 25 to 54; and 3) the unemployment rate. Together the figures indicate that in April 2021 the recovery from the worst effects of the pandemic on the labor market was well underway, but there was still a long way to go.

NEW! – 04/16/21 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss monetary policy and the tools available to the Federal Reserve.

Authors Glenn Hubbard and Tony O’Brien follow up on last week’s fiscal policy podcast by discussing monetary policy in today’s world. The Fed’s role has changed significantly since it was first introduced. They keep an eye on inflation and employment but aren’t clear on which is their priority. The tools and models used by economists even a decade ago seem outdated in a world where these concepts of a previous generation may be outdated. But, are they? LIsten to Glenn & Tony discuss these issues in some depth as we navigate our way through a difficult financial time.

Just search Hubbard O’Brien Economics on Apple iTunes or any other Podcast provider and subscribe! Today’s episode is appropriate for Principles of Economics and/or Money & Banking!

Please listen & share!

COVID-19 Update – The Double-Edged Sword of Unemployment Insurance

Supports:  Econ (Chapter 19) & Micro (Chapter 9): Unemployment and Inflation; Essentials: Chapter 13.

Apply the Concept:  The Double-Edged Sword of Unemployment Insurance  

Here’s the key point:  Unemployment insurance payments during the pandemic cushioned worker income losses but made layoffs more likely and made some workers reluctant to return to work.

            When workers lose their jobs, they are usually eligible for unemployment insurance payments. State governments are responsible for funding the payments, although the federal government provides guidelines states must meet and contributes funds to pay for administering the program.  As the following figure shows, the U.S. experienced an extraordinary surge in weekly unemployment insurance claims during April 2020. The increase in claims was much greater than occurred at any point during the Great Recession of 2007-2009, which was the most severe recession the U.S. economy had experienced since the Great Depression of the 1930s.

The spike in people losing their jobs and applying for unemployment insurance was primarily due to many mayors and governors ordering the closure of nonessential businesses to fight the spread of the Covid-19 disease caused by the coronavirus.  Unemployment insurance payments vary across states but typically last for 26 weeks and are intended to replace about 50 percent of a worker’s wage, subject to a cap.  In 2020, Congress and President Donald Trump enacted the Coronavirus Aid, Relief, and Economic Security (CARES) Act to provide funds to support firms and businesses suffering from the effects of the coronavirus pandemic. Included in the act was a provision to increase the normal state unemployment insurance payment by $600 per week for up to four months.

Congress and President Franklin Roosevelt created the U.S. unemployment insurance system during the Great Depression as part of the Social Security Act of 1935. The first payments were made in 1939.  Congress has had two main goals in establishing and maintaining a system of unemployment insurance: (1) To provide the means for workers who have lost their jobs to continue to buy food, clothing, and other necessities; and (2) to help support the level of total spending in the economy to avoid making recessions worse.  From the beginning, some members of Congress and some state legislators were concerned that payments to the unemployed would reduce the recipients’ incentive to quickly find a new job.  In establishing the program in the 1930s, policymakers were influenced by the experience in England where high rates of unemployment throughout most of the 1920s had resulted in many people receiving government payments—being “on the dole”—for years. In reaction, most states established 26 weeks as the length of time the unemployed could receive payments and kept the amount of money at roughly half a worker’s previous wage.

Economists believe that any type of insurance results in moral hazard, which refers to the actions people take after they have entered into a transaction.  In particular, insurance makes the event being insured against more likely.  For instance, once a firm has purchased a fire insurance policy on a warehouse, it may choose not to install an expensive sprinkler system thereby increasing the chance that the warehouse will burn down.  People with health insurance may visit a doctor for treatment of a cold or other minor illness, which they would not do if they lacked insurance. Similarly, moral hazard resulting from the unemployment insurance system may result in workers not accepting jobs that they would have taken in the absence of unemployment insurance.

Economists debate the extent to which the moral hazard involved in unemployment insurance has a significant effect on U.S. labor markets.  Most studies indicate that unemployment does increase the length of time that workers are unemployed—the duration of spells of unemployment—thereby reducing the efficiency of the economy by decreasing the size of the labor force and the quantity of goods and services produced.  But because unemployment insurance reduces the opportunity cost of searching for a job—since workers give up less income during the time they are searching—it may also result in a better fit between workers and jobs, thereby increasing worker productivity and economic efficiency.  Most economists conclude that, on balance, unemployment insurance that lasts for only 26 weeks and replaces only 50 percent of previous income probably does not significantly reduce economic efficiency in the United States.

            After passage of the CARES, some policymakers and economists again raised the issue of whether the unemployment insurance system provides disincentives for people to work.   The additional $600 that an unemployed worker received under the CARES act increased the average unemployment insurance benefit from $378 per week to $978 per week. That income was equivalent to a wage of $24.45 per hour for a 40-hour week and was greater than the wage rate received by more than half of workers in the United States in early 2020, before the coronavirus pandemic began.  As a result, some workers were reluctant to return to their previous jobs as some firms began to reopen during May.

A restaurant owner in Oregon noted that one of his cooks was receiving $376 more per week in unemployment insurance than he had earned working: “Why on earth would he want to come back to work?” The restaurant was having difficulty attracting enough workers to provide takeout and delivery services while the restaurant’s dining room was closed. As the head of the National Restaurant Association put it: “It’s not that these workers are lazy, they’re just making the best economic decision for their families.”

Some firms that were unsure whether to continue to employ workers during the period the firms were ordered closed. Retaining workers would make it easier to restart once mayors and governors had lifted restrictions on operating. But the availability of higher unemployment insurance payments made some of these firms decide to lay off workers instead. For example, according to an article in the Wall Street Journal, Macy’s chief executive stated that “the new benefits in the federal stimulus program played a role in the company’s decision to furlough 125,000 workers this past week.”

The supplementary unemployment insurance payments included in the CARES act succeeded in cushioning the income losses workers suffered from the layoffs during the pandemic, but they had also made it more likely that firms would lay off workers and made some workers more reluctant to return to work. Given that the additional $600 payments were scheduled to end after four months, it remained unclear whether the payments would have a lasting effect on the U.S. labor market.

Sources: Kurt Huffman, “Our Restaurants Can’t Reopen Until August,” Wall Street Journal, April 12, 20202; Eric Morath, “Coronavirus Relief Often Pays Workers More Than Work,” Wall Street Journal, April 28, 2020; Patrick Thomas and Chip Cutter, “Companies Cite New Government Benefits in Cutting Workers,” Wall Street Journal, April 7, 2020; Henry S. Farber and Robert G. Valletta, “Do Extended Unemployment Benefits Lengthen Unemployment Spells? Evidence from Recent Cycles in the U.S. Labor Market,” Journal of Human Resources, Vol. 50, No. 4, Fall 2015, pp. 873-909; Congressional Budget Office, “Understanding and Responding to Persistently High Unemployment,” February 2012; Daniel N. Price, “Unemployment Insurance, Then and Now, 1935-85,” Social Security Bulletin, Vol. 48, No. 10, October 1985, pp. 22-32; and Federal Reserve Bank of St. Louis.

Question: An article published in the New York Times during April 2020, quoted a policy analyst as stating that: “I would never two months ago have ever thought of advocating for 100 percent income replacement.”

  1. What does the analyst mean by “100 percent income replacement”?
  2. Why during an economic expansion or mild economic recession would most policymakers be reluctant to adopt a policy of 100 percent income replacement?
  3. Are there benefits to such a policy during an economic expansion or mild economic recessions? How is the desirability of such a policy affected if the economy is in a severe recession?

SourceElla Koeze, “The $600 Unemployment Booster Shot, State by State,” New York Times, April 23, 2020.

For Economics Instructors that would like the approved answers to the above questions, please email Christopher DeJohn from Pearson at christopher.dejohn@pearson.com and list your Institution and Course Number.