Did the Fed inadvertently shift to a fairer monetary policy regime?
There’s a lot going on here, but bear with us.
Before their shift to ‘flexible average inflation targeting’ (FAIT) last year, the policy of the US Federal Reserve was to target inflation of around 2% and to minimise deviations from ‘full’ employment. That policy had officially been in place since 2012, but the general aim of achieving stable inflation and employment had been around for some time before that.
The policy meant that – implicitly but quite consistently – the Fed would begin to raise interest rates when unemployment fell below around 6%. That rate of unemployment was considered to be the (approximate) ‘natural’ rate of unemployment, sometimes referred to as the ‘non-accelerating-inflation rate of unemployment’, or NAIRU. The natural rate of unemployment is considered by economists to be the rate at which all people who want jobs have them, at any given time. If you want to get more technical, the natural rate of unemployment is the one where only structural, and not cyclical unemployment exists, according to economists. For simplicity, take ‘structural’ to mean largely permanent, and ‘cyclical’ to mean largely temporary. So, the reason the Fed tended to hike when unemployment was below the NAIRU was that they were concerned that inflation might start to rise, and since their policy was to target stable inflation, they raised interest rates to ‘cool down’ the economy and keep inflation contained.
Since 2012, however, a lot has happened. Most importantly, estimates of what level of interest rate is consistent with the Fed’s objectives have fallen considerably. That means it is expected to take lower and lower interest rates to keep hitting the Fed’s targets. Clearly that’s unsustainable because interest rates can’t keep falling forever. The Fed’s solution to this in their 2020 policy shift was to take an approach that would allow inflation to creep above 2% and stay there for some time, so as to allow inflation to ‘make up’ for all the times when it has undershot 2% in the past. They also explicitly conceded that they don’t know what the natural rate of employment is (implicitly saying that it is probably lower than 6%), and so no assumption about it should be made in the decision about whether to change interest rates. Both of these shifts in policy mean that the Fed is now willing to allow the economy to ‘run hot’ for a while before they cool it down.
Which brings us to our suggestion that a hotter economy – or hotter labour market – might actually be a fairer one. The scatter chart below plots the total US unemployment rate against the black-minus-white unemployment rate gap from 1972 to 2020. Don’t ask us why white unemployment rate data is available from 1954 but black unemployment rate data is only available from 1972 (total unemployment rate data is available from 1948). The chart shows that the tendency of the Fed to raise interest rates at around 6% not only prevented further increases in total employment (which was intentional, because they were worried about inflation) but also prevented further falls in the gap between black and white unemployment rates. We emphasize the word gap because this chart suggests that if the natural rate of total unemployment was indeed around 6%, the level of black unemployment was still some way above its natural rate when the Fed hiked. So, the economy could have created more black employment without creating more inflation, which would have been tolerable to the Fed. So – perhaps at a stretch – the structural gap in black-white employment rates may have persisted because of the Fed’s monetary policy approach.
Source: To the pound, US Bureau of Labor Statistics, US Federal Reserve, February 2021
We think we can give the Fed the benefit of the doubt: they probably didn’t intentionally target a structural black-white employment gap. We also don’t make any judgement about which is worse: a black-white employment gap or above-target inflation. But we do think that observations like this are worth investigating further in case government and central bank policies can be enhanced in such a way that might help to reduce inequality, as opposed to targeting broad economic measures that ignore structural inequality. The Fed’s shift in policy last year probably didn’t have inequality in mind, but allowing the economy to ‘run hot’ might inadvertently have meant a slightly fairer monetary policy. Perhaps one day they’ll mean to do it.
(To be fair, we should say: there is some evidence that the Fed understands the points we make in this article. Fed Governor Lael Brainard mentioned the black-white unemployment gap in a recent speech she made, which you can find here).
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To the pound 