The Federal Reserve has given specific numerical guidance on only one of its objectives: A two percent rate of inflation. A press release that followed the January meeting of the Federal Open Market Committee (FOMC) gave further clarity to this monetary policy goal by announcing that the Committee views its inflation objective as symmetric and “would be concerned if inflation were running persistently above or below” two percent. Because the inflation rate has been less than two percent since the second quarter of 2012 and less than 1.5 percent since the fourth quarter of 2014, this press release would appear to have, as a clear and immediate implication, that the FOMC plans to maintain the accommodative stance of its monetary policy to ensure that inflation returns to target.
By statute, the Fed also must pursue a second objective: “Maximum employment.” Discussions of this goal, however, have confused both the priorities of monetary policy and notions about which data would lead the Fed to conclude that “maximum employment” had been reached. For example, at the time of its December 2013 meeting, the FOMC indicated it would consider tightening policy if the unemployment rate fell below 6.5 percent. Standing then at 6.7 percent, the unemployment rate had fallen to 6.2 percent by April 2014. Rather than tightening at that point, however, the FOMC delayed for another 12 meetings before finally increasing its federal funds rate target by 25 basis points in December 2015, when the unemployment rate stood at 5 percent – a full 1.5 percentage points below what the Committee once had announced as a signal for action.
Announcing quantitative objectives for unemployment and attaching so much weight to them in FOMC policy statements was a mistake. Of course, since monetary policy is made under conditions of uncertainty, some mistakes will result from bad luck alone. In this case, however, the Fed’s excessive focus on unemployment was bound to lead to error. While most economists agree that monetary policy can affect unemployment, all are aware that the unemployment rate gets buffeted over both short and long horizons by a multitude of other factors. Setting and hitting a numerical target requires a degree of control over unemployment that the FOMC simply does not have.
Furthermore, economists know that the unemployment rate often can send misleading signals of the economy’s overall strength. A previous E21 column showed how the unemployment rate (ur), defined as the number of unemployed persons as a fraction of the total labor force, can be re-expressed as ur = 1 – (er/lfp), where the employment ratio (er) is the number of employed persons as a fraction of the total population and the labor force participation rate (lfp) is the number of persons either employed or looking for work as a fraction of the population. This expression reveals that the unemployment rate declines when there is an increase in the employment ratio; this would suggest a stronger economy. On the other hand, the expression also shows that the unemployment rate declines when the labor force participation rate falls; this might signal a weaker economy if there has been an increase in the number of discouraged workers who have given up looking for jobs and left the labor force entirely.
In fact, over the two-year period from December 2013, when the Fed suggested it might tighten if the unemployment rate fell to 6.5 percent, and December 2015, when it did tighten with unemployment at 5.0 percent, the employment ratio increased from 58.6 to 59.5 percent, but the labor force participation rate declined from 62.9 to 62.6 percent. These figures highlight what most American workers already know: that recent declines in the unemployment rate, though welcome news on balance, overstate how much improvement has taken place in the US labor market over the past two years.
Of course, data on inflation are subject to problems of measurement and interpretation as well. Sharply falling energy prices and the effects of a strong US dollar on the prices of imported goods have exerted strong downward pressure, distorting recent inflation figures. All economists agree, however, that monetary policy remains the principal determinant of inflation in the long run. With that most basic fact in mind, two key questions arise for FOMC members. First, once the transitory effects of changes in oil prices and the foreign exchange value of the dollar wear off, where will the trend rate of inflation lie? And, second, has enough monetary stimulus already been applied to bring the trend in inflation back to two percent? If Fed officials resolve to answer these questions not only be reaffirming their objectives for inflation but also by taking actions that are consistent with them, better monetary policy surely will be the result.