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Tags: federal reserve | interest rates | inflation | jobs | u.s. economy

Fed's Hopes for Low Inflation, Job Boom May Fall Flat: Economists

Federal Reserve Chairman Jerome Powell's unique approach to monetary and fiscal policy has been dubbed the "Powell Paradigm." (AP)

Friday, 18 February 2022 10:16 AM EST

When the Federal Reserve tacked to a new brand of monetary policy 18 months ago, it thought it could deliver low unemployment and tame inflation.

It may end up with neither.

That's according to a critique by five top bank and academic economists released on Friday that envisions a scenario in which Fed Chair Jerome Powell and his colleagues are unable to control high inflation and forced into a "very costly" decision to raise interest rates so high that the economy slows and unemployment escalates -- erasing gains for the very workers policymakers had hoped to help.

Officials on the 'Powell Paradigm'

Two U.S. central bank officials -- one of whom helped design the Fed's new playbook and another relative newcomer who has more aggressively flagged inflation concerns -- will be called on Friday to assess the authors' analysis at a symposium organized by the University of Chicago Booth School of Business.

The new approach, dubbed the "Powell paradigm" by the writers, was adopted in August 2020 and, based on how the economy had behaved for the last decade, aimed to drive employment as high as possible while anticipating inflation could be held near the Fed's 2% target.

The perceived benefits were valid. The authors found that periods of low unemployment, like the current one with jobless rates of around 4%, do help narrow the persistent gaps between, for example, white, Black and Hispanic workers, and between those with more education versus those with less.

But the COVID-19 pandemic and the policy responses to it have now "upended some of the premises" on which the new approach rested, and in particular have left the Fed facing inflation that has reached levels not seen since the 1980s, wrote Morgan Stanley's Seth Carpenter, Bank of America's Ethan Harris, Deutsche Bank's Peter Hooper, University of Chicago professor Anil Kashyap, and University of Wisconsin professor Kenneth D. West.

They said it is possible the Fed will be able to lower the pace of price increases with steady but ultimately modest increases to its benchmark overnight interest rate, from the current level near zero to around 3% between now and 2024, without triggering big changes in the unemployment rate - the ideal scenario for policymakers.

Public Psyche

Favorable public psychology, with firms and households acting as if inflation will remain under control, does "most of the work ... Therefore, the Fed neither has to be pre-emptive in heading inflation off nor does it have to crush the economy" to win back control, the group wrote.

But from there the tradeoffs worsen. Under simulations they developed, and depending on whether the post-pandemic economy includes more or less of a tradeoff between inflation and jobs, the Fed could be forced to raise interest rates perhaps twice as high, see inflation remain elevated, and the unemployment rate get lodged between 5% and 6% for several years.

That would be a blow to Fed hopes for a "broad and inclusive" recovery in the U.S. labor market, with the higher unemployment rate falling hardest on racial and ethnic minorities and less educated Americans.

The results "raise some questions for the Federal Reserve going forward" if, after promising it could deliver stable inflation and low unemployment, policymakers again have to make a choice.

"Either outcome, exacerbating inequality or accepting years of high inflation, is fraught with political risk," they concluded.

Evans, Waller to Comment Today

Chicago Fed President Charles Evans, a key architect of the new Fed framework, is due to speak at the Booth event, as is Fed Governor Christopher Waller, who has been among the more outspoken in saying the central bank needed to move quicker to control inflation.

The Fed is due to hike interest rates at its March 15-16 policy meeting. Yet minutes of the central bank's most recent discussion in January acknowledge the gamble officials took by leaving ultra-loose monetary policy, of near-zero interest rates and monthly purchases of bonds, in place as long as it did.

Inflationary forces that had been seen as "transitory" were now broadening through the economy, the minutes noted, and had begun influencing business investment and wage decisions in ways that could persist.

That's the sort of dynamic that Carpenter, Harris and the other authors noted could force the Fed into tougher policy choices: If recent inflation experience informs what businesses or households expect to happen in the future and how they invest and spend as a result, it might require more aggressive rate increases - and worse employment outcomes - to reverse that thinking.

The emphasis on jobs "has potentially earned the Fed some good will," the authors said. "But when the next recession comes and inequality rises ... what will be the fallout?"

© 2023 Thomson/Reuters. All rights reserved.

When the Federal Reserve tacked to a new brand of monetary policy 18 months ago, it thought it could deliver low unemployment and tame inflation. It may end up with neither.
federal reserve, interest rates, inflation, jobs, u.s. economy
Friday, 18 February 2022 10:16 AM
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