Whether it’s the existing approach to inflation targeting or the newfound belief in average inflation targeting, the Fed’s fixation with the price level leaves it vulnerable to policy errors, especially in the current context. The summer of 2008 and the first half of 2011 are critical examples for understanding how the prioritization of inflation outcomes can mislead market participants and FOMC members about the optimal path for monetary policy. In both of these episodes, the US economy was decelerating but financial markets and policymakers were distracted by transitory price acceleration. The result was monetary policy and financial conditions that were tighter than would otherwise be optimal.

The Fed’s evaluation of its policy stance in the 2010s — that it was insufficiently accommodative—is correct, but its remedy for this bias is fundamentally flawed. The Fed has signaled a deeper commitment to the symmetric achievement of its 2% inflation target, through a variant of an average inflation targeting strategy that explicitly targets a inflation rate higher than 2% when inflation has run persistently below 2%. As well-intentioned as this strategy might be, it is equally vulnerable to the scenarios of 2008 and 2011, when temporary price level acceleration motivated tighter monetary policy and financial conditions, even though the economy itself was decelerating. Even if the Fed manages to correctly identify such inflationary developments as transitory, it will still face the challenge of convincing market participants to “look through” such noise. This could prove especially challenging if the Fed invests heavily in educating the public about the improvements and innovations associated with its latest iteration of inflation targeting.

The Inflation Distraction of 2008

The 2008 experience began with a series of accommodative measures. The Federal Open Market Committee (FOMC) first lowered its target for the federal funds rate from 4.25% to 3.00%. Chair Bernanke also successfully advocated for Congress and the White House to pass the Economic Stimulus Act of 2008. In March, the Fed short-circuited financial panic by questionably subsidizing JP Morgan’s acquisition of the troubled Bear Stearns. By the April FOMC meeting, the federal funds rate target had been lowered to 2% and financial markets were showing signs of stabilization.

Despite evidence that monetary policy was providing marginal support to financial markets and fiscal stimulus provided a short-term boost to consumption, the underlying economic trends were continuing to deteriorate.

The housing bust was still in full train and the unemployment rate was still moving higher. Nonfarm payrolls were continuing to decline at a worrying rate. Yet if you were simply following the Fed’s own words in the summer of 2008, you would get a very different perspective. On June 10, 2008, the Wall Street Journal ran with the headline “Bernanke Unshaken by Jobless Rise”

“ The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so” — Chair Bernanke

“Containing the risks in what is globally a less benign inflation environment is going to probably require tighter monetary policy on average around the world” — New York Fed President Tim Geithner

While the economy was still sinking further into recession, financial markets and FOMC members were more concerned that the economy was about to repeat the high inflation of the 1970s, and not the depressed economic activity of the 1930s. Through a narrative fueled by optimism about growth in emerging markets, pessimism about the US dollar, and concerns about resource scarcity, commodity prices boomed and the price of oil reached an all-time high.

The European Central Bank even raised interest rates in June of 2008, which in turn put additional downward pressure on the US dollar in foreign exchange markets.

These overshooting dynamics were more obvious in retrospect and their effects on inflation ultimately proved to be closer to a one-off. Trends in nominal income and spending growth reflected the opposite trend throughout this period.

The pivotal question in the summer of 2008 was which trend would prove to be signal and which to be noise. While the Fed ultimately grew more attentive to the risks of deteriorating output, employment, and spending, it took several intervening events to come around to this view.

At the time, market expectations reflected a hawkish path for Fed policy, with interest rate futures pricing in more than three 25 basis point hikes before the end of 2008.

Market predictions weren’t just incorrect, but costly in terms of their effect on financial conditions. At a time when lower long-term interest rates could have supported existing spending and economic activity, the expectation for Fed hikes tightened financial conditions and increased the cost of capital for businesses and households.

In August, commodity prices and exchange rates began to factor in the risk of US economic deceleration spilling over to the rest of the global economy. With every new headline in August about Lehman’s attempt to raise capital, financial markets reflected less concern about mounting inflation and more concern about the risk of a financial crisis. Yet even as financial markets began to shift their attention away from inflation risks and towards the underlying growth risks, the Fed was much slower to pivot. Despite the full-blown collapse of Lehman Brothers, the FOMC chose not to lower interest rates at its September meeting. This reluctance to ease policy was directly tied to concerns about overshooting and self-perpetuating price acceleration.

As the financial crash and crisis spun out of control in the ensuing weeks, the Fed finally shifted its full attention to the deteriorating recession. One wonders how much damage could have been mitigated had the Fed not allowed inflation-centrism get in the way of more decisive action to fight the Great Recession.

The Inflation Distraction of 2011

“Fool me once…shame on you. Fool me — you can’t get fooled again.”

The lessons of 2008 should have been relatively fresh in the minds of FOMC members and financial market participants. For all of the hype about the inflationary implications of rising commodity prices and a depreciating dollar, the underlying trends in nominal and real economic activity proved to be a more reliable guide of central bank policy and even the future path of inflation.

From the end of 2010 through the first half of 2011, we saw the dynamics present in the summer of 2008 make a reappearance. After the Fed’s second round of large scale asset purchases, also known as “QE2”, was announced in October 2010, commodity prices began to see another mini-boom that only concluded in late May of 2011.

Yet even during this acceleration of inflation, the nascent employment recovery from the Great Recession was faltering. Payroll employment gains were slowing, the unemployment rate was flat-lining and the prime-age 25–54 employment-to-population ratio was continuing to decline.

Despite all of this, financial markets at least temporarily anticipated that the Fed would consider as much as 225 basis points of tightening over the following two years. Some of this pricing reflects the unique asymmetry that the zero lower bound imposes; future hikes are inherently more likely than future cuts. Yet even after accounting for the zero lower bound asymmetry, this was an especially hawkish set of market expectations for Federal Reserve policy. Markets were evidently more inclined to think that the Fed would be more concerned about risks associated with accelerating headline inflation than with the prospect of a double-dip recession.

Chair Bernanke consistently communicated a more dovish outlook throughout this period and advocated for looking through the past the temporary rise in commodity prices.

“On the inflation front, commodity prices have risen significantly recently, reflecting geopolitical developments and robust global demand, among other factors. Increases in commodity prices are in turn boosting overall consumer inflation. However, measures of underlying inflation, though having increased modestly in recent months, remain subdued, and longer-term inflation expectations have remained stable. Consequently, the Committee expects the effects on inflation of higher commodity prices to be transitory; as the increases in commodity prices moderate, inflation should decline toward its underlying level” — Chair Bernanke at press conference following the April 2011 FOMC Meeting

That said, Chair Bernanke’s views did not enjoy a comfortable consensus within the Federal Open Market Committee

Citing the jump in energy prices, [Philadelphia Fed President Charles] Plosser said “the reason oil prices worry me is that there will be more pressure to keep monetary policy easier for longer” as some fear these price gains will hold back growth by reducing households’ spending power. “That response is a response that will in my view” create inflation, and “we need to lean against that,” the policy maker said.

Chair Bernanke was right: rising inflation of this period proved to be temporary, and the growth slowdown of 2011 proved to be the more important risk, especially with the onset of a sovereign debt crisis in the Eurozone and a more austerity-inclined approach to domestic fiscal policy.

The deterioration in the growth outlook, alongside a leveling off of price pressures, ultimately led the Fed to expand its set of accommodative monetary policies.

That financial market participants were sidetracked by temporary price acceleration should be instructive to how the Fed shifts its framework and strategy. Fed communication of the inflation outlook will not always align with how financial markets perceive inflation dynamics. As a result, long-term interest rates may be higher and financial conditions tighter than where the Fed would otherwise prefer them to be.

Average Inflation Targeting Will Not Insulate The Fed From The Policy Errors and Dilemmas of 2008 & 2011

The Fed thinks the problem with its current approach to inflation targeting is that the inflation outcomes have not been symmetric. Headline and core inflation have persistently undershot the 2% target it adopted in January 2012.

In some ways, this does reflect a broader failure, albeit imperfectly. Whether you look at nominal wages, gross labor income or nominal GDP, growth rates have been systematically lower since 2008 and have failed to return to the pre-crisis trend. Yet the scale of these losses reflect something far more significant and materially tied to the Fed’s “maximum employment” mandate than what the inflation undershoot captures.

While core inflation only barely reached 2% in the 2010s expansion, headline inflation has had its share of circumstances during which it grew materially above the 2% inflation target. In both 2008 and 2011, the Fed’s actual and perceived reaction function were highly distorted by these developments. How would an average inflation targeting strategy, in which the Fed were to pursue a modestly higher inflation rate in the short-run, leave the Fed any less vulnerable to the same problem?

If anything, the Fed’s strategic framework review has reiterated the importance of the inflation target and raises the risk of another inflation distraction if similar economic circumstances arise. At a time of historically low labor utilization, it would be tragic if the Fed or financial markets were sidetracked by inflationary developments that ultimately served to delay or derail economic recovery. Too many jobs, businesses, and incomes are already at risk for the Fed to allow the same error to occur yet again.

In contrast to average inflation targeting, aiming to put a floor under gross labor income growth would provide the Fed and market participants with a more reliable anchor for calibrating the scale and timing of monetary policy accommodation.

Authors: Skanda Amarnath & Sudiksha Joshi

The previous post made the case for why the Evans Rule, when evaluated in the full context of fiscal austerity and a deleveraging household sector, was an underrated policy success. Here, we discuss six potential improvements to the Evans Rule that the Federal Reserve (Fed) should consider as it formulates its forward guidance strategy in response to the COVID-19 economic crisis.

Summary

While the Fed’s capacity is more limited when interest rates are already at the zero lower bound (ZLB), it can still play a powerful supporting role by concretely committing to keep interest rates low for as long as is needed to achieve a full recovery in employment and wages. The ideal policy for the Fed to adopt right now is a commitment to keep the federal funds rate at the zero lower bound so long as long-term inflation expectations remain anchored at (or below) 2% and the following two conditions hold:

1. Labor utilization, preferably measured using the prime-age 25–54 employment-to-population ratio or Ernie Tedeschi’s demographically-adjusted NPOP measure, remains below the level achieved in the fourth quarter of 2019 (80.3% and 40.2% respectively).
2. Wage growth, preferably measured using the employment cost index for either wages and salaries or total compensation, remains below its year-over-year growth rate in the fourth quarter of 2019 (2.7% and 3.0% respectively).

The Fed should also be willing to revise these thresholds quickly when it becomes clear that more labor market progress is achievable, or if the chosen indicators seem to exhibit some distortions. Dynamic revision is particularly helpful if the Fed initially opts for less ambitious thresholds than what is suggested above.

Our proposed set of improvements:

1. Replace the focus on price inflation projections with an emphasis on nominal wage growth. Instead of relying on internal projections of future consumer price inflation, the Fed should tie forward guidance to realized wage growth using the employment cost index. By relying on opaque projections of consumer price inflation, the Evans Rule diminished the extent to which forward guidance could have shaped expectations about the future path of interest rates. While market participants and economic actors can more transparently observe actual price inflation readings, these readings can be highly volatile and idiosyncratically driven, thereby resulting in more arbitrary policymaking. Given the speed and depth of the economic shock associated with COVID-19, price inflation readings are even more likely to be volatile in the current environment, misleading policymakers with one-off methodological quirks. Unlike price inflation, wage growth is more sensitive to changes in labor utilization and economic activity.
2. Replace the ceiling with a floor. The systematic problem with Fed policy over the past decade has been insufficient nominal income growth, not excess inflation. The inflation component of the Evans Rule was set up as a ceiling; only if projections of inflation exceeded 2.5% would the Fed exit its zero interest rate policy (ZIRP). While a ceiling is more politically intuitive in the context of price inflation (who deliberately wants to see more price inflation?), a baseline floor is the better approach with respect to wage growth. Aiming for a floor rate of price inflation may be functionally workable, and Philadelphia Fed President Patrick Harker even suggested as much in a recent speech, but wage growth is a more politically attractive benchmark when the true objective is to actively “heat up” the economy.
3. The labor utilization threshold should be a necessary “level target” condition but not an individually sufficient condition for ending state-based forward guidance. While the validity of the Phillips Curve and the natural rate of unemployment rate have been rightfully questioned in recent years, the Fed should retain a baseline target for labor utilization. In its absence, any threshold that solely turns on the rate of price inflation or nominal wage growth is vulnerable to the the “level versus change” problem that Neil Irwin recently highlighted. We’ve seen a precipitous drop-off in economic activity followed by bits and pieces of recovery. While monthly developments are optically extreme in terms of growth rates, the overall level of economic activity provides a more stable and holistic picture. The case for adopting some form of a level target is stronger in the context of the current crisis as a result. Provided that “longer-term inflation expectations continue to be well anchored,” achievement of both the thresholds for wage growth and labor utilization should be a necessary condition for ending forward guidance. While there is some risk that consumer prices accelerate before labor utilization nears its specified threshold, retaining the Evans Rule’s escape clause regarding inflation expectations curbs the risk of a sustained de-anchoring to the upside. The Fed has continued to reiterate that its 2% inflation target is a symmetric target, in which case there should be some additional tolerance for above-target inflation in light of their systematic bias for below target inflation.
4. Choose a more robust measure of labor utilization than the U-3 unemployment rate. The impact of the Evans Rule was stymied by the choice of the U-3 unemployment to capture labor utilization. The unemployment rate declined surprisingly quickly in 2013 because measures of labor force participation were also declining at the same time. Those declines in participation ultimately reversed course later in the business cycle expansion but nevertheless impacted forward guidance based on the Evans Rules. The prime-age 25–54 employment-to-population ratio would serve as a straightforward solution to this flaw because it does not rely on the blurry distinctions between nonparticipants and the unemployed, which are difficult to categorize consistently in the Current Population Survey. Ernie Tedeschi’s demographically-adjusted “NPOP” series, while more complicated and less well-known, would be ideally suited to capture the full magnitude of labor market slack, including those who are part-time underemployed.
5. Initially presume against “structural” shifts. If the Fed proceeds with quantitatively defined state-based forward guidance in the form of Evans Rule thresholds, it should presume against any notion that there has been a sudden rise in structural unemployment or a structural decline in the level of sustainable wage growth. The purpose of a reformulated Evans Rule should be to recover the labor market that preceded the onset of COVID-19, when the prime-age 25–54 employment-to-population ratio was above 80% and the employment cost index was growing at approximately 3% year-over-year. The economy was not suffering from overheating prior to the onset of the pandemic. If anything, the systematic under-performance of inflation and wage growth suggested that monetary policy could continue to err on the side of accommodation. While there are always interesting stories about how the world has fundamentally changed since the pandemic, the wrongheaded claims following the Great Recession about structural unemployment should serve as a cautionary tales.
6. Revise the thresholds in the face of new information about the labor market. The Fed had to continuously revise down their estimates of the natural rate of unemployment in the years following the Evans Rule. Chair Powell even admitted that the Fed had systematically underestimated the potential for greater labor market progress without aggravating inflationary pressures. If the Fed chooses to adopt more conservative thresholds, then it should at least be willing to revise such thresholds in the absence of upward inflationary pressures. The prior expansion should be instructive here; higher labor utilization and wage growth were not associated with sustained above-target consumer price inflation. If we learn that the economy has more spare capacity, the Fed should move briskly to adjust to that reality.

Wage Floors, Not Price Ceilings

The Evans Rule was a qualified success, but if the Fed goes down the path of quantitative state-based forward guidance, there are still lessons to be learned. While the calibration of the rule in terms of a labor utilization metric and a nominal variable were a reasonable way to balance the Fed’s mandated objectives for maximum employment and price stability, it could have chosen better indicators to match those objectives.

Nominal Wages Deserve More Attention Than Consumer Prices, Projected or Actual

When the FOMC was first contemplating the Evans Rule, the debate was mostly concerned with curbing the risk of excess price inflation. A potential rise in structural unemployment and an elevated balance sheet were among the factors cited for why the economy was at risk of rising inflation. For these reasons, the Fed adopted an “inflation ceiling” as part of the Evans Rule:

“the federal funds rate will be appropriate at least as long as…inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal”

The inflation ceiling was expressed as a forecast, and not as actual inflation readings that are released each month. Fed staff rightly acknowledged that realized inflation readings were too volatile for reliably calibrating quantitative thresholds for state-based forward guidance. The reliance on an inflation projection was meant to help “look through” some of the local volatility in current inflation readings.

Yet the use of an opaque inflation projection ultimately defeats some of the potential benefits of state-based forward guidance. Forward guidance works to the extent it shapes the expectations of economic actors, but how should economic actors understand FOMC members’ projections for price inflation? Each member is likely to have a different model and theory regarding the factors driving inflation . These models and theories are further complicated by the heterogeneity of methodologies applied to component price indices, and are subject to revision over time in order to incorporate new forms of hedonic adjustment.

Spot and projected consumer price inflation are ill-suited to the local and structural challenges of macroeconomic policy. The Fed would be better off adopting quantitative thresholds that are rooted in nominal incomes or wages instead. Unlike consumer price indices, the employment cost index follows a much more consistent methodology over time. The employment cost index is also especially helpful for avoiding problems that plague other measures of wage growth, including selection biases, small sample size challenges, and aggressive revisions to previously reported data. Most importantly, wage growth is sensitive to developments in the broader economy in a way that consumer price inflation is not.

The Case For Floors Instead of Ceilings

Instead of setting a “ceiling” over projected consumer price inflation, a reformulated Evans Rule should be set as a “floor” under nominal wage growth, as measured by the employment cost index for either total compensation or wages and salaries. The inflation ceiling in the original Evans Rule was never breached during or after the period when the Evans Rule was in effect. If the Fed actually wants to escape the asymmetric costs of the ZLB, it will have to take affirmative steps to help engineer higher rates of nominal income and spending growth. An active floor is aligned with this objective in a way that the Evans Rule’s passive inflation ceiling was not.

Some FOMC members are already thinking along these lines. Philadelphia Fed President Patrick Harker suggested that the FOMC should condition any exit from ZIRP on first achieving 2% inflation. If not for some of the measurement quirks that plague inflation readings, such a precondition could be effective. But even if one looks beyond these quirks, there is a deeper question of political optics and intuitive communication that the Fed should consider carefully.

At a time when nominal income growth is historically weak, fixating on the rate of consumer price inflation confuses the objective with the byproduct. The problem of the past decade and the current context is one of inadequate nominal incomes, not insufficient price increases. The Fed has systematically undershot the 2% inflation target it adopted in January 2012, but the true cost of this policy failure is reflected in the abysmal pace of wage growth, which barely reached 3% during the previous expansion. Thus, in spite of historically low interest rates, economic outcomes of the past decade reveal that the Fed has consistently erred on the side of excessively hawkish policy.

If the Fed wants to end this era of chronically low inflation and income growth, an exit from ZIRP should be conditioned on achieving a sustainable rate of nominal wage growth. In the absence of accelerating nominal wage growth, upward pressures on price inflation alone merely reflect relative price changes.

The Role of Labor Utilization In State-Based Forward Guidance

The irony of the Evans Rule was that the component of the rule that was conventionally viewed as dovish, the unemployment rate threshold, actually proved to be the most hawkish in retrospect. David Andolfatto and Narayana Kocherlakota were among the outliers in foreseeing this dynamic. If the Evans Rule only involved an inflation threshold, the Fed’s urge to increase interest rates would have been kept at bay for a much longer period of time.

Of course, any policy rule must take into account alternative scenarios and not simply the ones that have played out. The memory of both 2008 and 2011 must have been fresh in the minds of policymakers, when oil prices and inflation readings temporarily surged amidst deteriorating economic conditions. Surely the last thing that some of the more vocal doves like Charles Evans and Eric Rosengren wanted to see was another red herring inflation surge distracting from the more glaring implications of elevated unemployment. Yet even in this scenario, the implementation of the labor utilization threshold within the Evans Rule was far from optimal.

The Labor Utilization Threshold As A Level Target — Necessary, But Not Sufficient For Ending Forward Guidance

The original Evans Rule was framed as an either-or proposition: either the unemployment rate falling below 6.5% or price inflation projections exceeding 2.5% would end the Fed’s state-based forward guidance policy. Yet even as the unemployment rate declined past 6.5%, there were few signs of a sustained acceleration in prices. Actual inflation readings barely reached 2% and never sustainably reached the 2.5% ceiling even in the years after the Evans Rule when the unemployment rate reached 3.5%. It took another four years after the conclusion of the Evans Rule for hourly compensation to grow at a rate roughly consistent with 2% inflation and a 1% growth rate in productivity.

The relevance of a labor utilization threshold would have been much more powerful if achievement of both Evans Rule thresholds were a necessary condition for ending state-based forward guidance with respect to ZIRP. This would make Region 2 and Region 3 of David Andolfatto’s grid the same as Region 4.

This aggressive approach to forward guidance might not have been politically feasible in December 2012 given that the hawks on the FOMC were also worried that the inflation ceiling in the Evans Rule was too high for it to be the pathway for ending forward guidance. Current FOMC members might be more open to such an approach, especially if the Fed substituted a wage growth floor for the prior inflation ceiling.

With the benefit of hindsight, it is tempting to claim that there never should have been a labor utilization component of the Evans Rule in the first place. The validity of the Phillips Curve and the natural rate of unemployment rate looks increasingly questionable; even as the unemployment rate achieved new lows through the expansion, wage growth and price inflation also remained historically low.

However, in volatile macroeconomic environments, a snapshot of growth rates (whether in terms of wages, prices, output, or employment) rarely tells the full story. May and June saw the strongest nonfarm payroll growth in over 70 years!

Nonfarm payroll employment is still nearly 10% below its February peak.

While I could reiterate some of the technical arguments for level targeting schemes, the case for targeting a specific level of labor utilization is rooted in a simpler purpose: retaining context. Short-term shifts in economic activity can appear optically extreme in terms of growth rates, but the level of economic activity provides a more stable and holistic picture. The case for adopting a level target is stronger in the context of the current crisis because of the unpredictable nature of the public health crisis and its historic impact on economic activity.

The risk associated with the suggested approach would be a significant overshoot of the 2% inflation target prior to reaching the chosen labor utilization threshold. In light of the Fed’s systematic bias for below-target inflation, the Fed should be comfortable with some risk of an inflation overshoot if it is committed to symmetric outcomes around the 2% target, as long as long-term inflation expectations appear reasonably anchored. Should long-term inflation expectations show some vulnerability to the upside as a result of a an overshoot, the Fed should have the option, just as they did with the Evans Rule, to adjust accordingly. That said, the fact that long-term inflation expectations stayed anchored amidst the string of downside misses over the past decade suggests there should be commensurate tolerance for upside surprises.

Moving Past The Unemployment Rate

The first major error of the Evans Rule was to calibrate ZIRP according to the level of the unemployment rate. While changes in the unemployment rate are a valuable indicator of cyclical inflection points, the Current Population Survey (CPS), from which the unemployment rate is derived, is not able to consistently delineate the unemployed from labor force nonparticipants. As a result, labor force participation is not as well-defined in practice as it is in concept.

This weakness in the Evans Rule was exposed in 2013, when the unemployment rate fell rapidly due to declining labor force participation rather than stellar job growth. As a result, the Evans Rule was in place for a much shorter time than it should have been.

The Evans Rule met its premature end in March 2014, and the Fed spent most of 2014 and 2015 laying the groundwork for raising interest rates, which helped stoke a historic appreciation of the US dollar against foreign currencies and ultimately fostered a slowdown in exports and business fixed investment.

There are superior labor utilization metrics that cut through this measurement problem associated with the headline U-3 unemployment rate. Employment-to-population ratios (EPOPs) are invariant to the distinction between unemployment and nonparticipation. While the headline employment-to-population ratio does not adjust for age composition, focusing on the prime working age (25–54) cohort offers a simple but effective adjustment. The commensurate declines in prime-age EPOP associated with a 1.3% decline in the unemployment rate took an additional year to achieve. Had the Evans Rule been in place for that period, the 2014–16 economic slowdown would likely look very different.

Although not as mainstream as prime-age EPOP, Ernie Tedeschi’s demographically-adjusted NPOP would be the ideal labor utilization metric for formulating state-based forward guidance. Tedeschi’s measure involves a more comprehensive and systematic adjustment for demographic shifts. NPOP also accounts for changes in part-time underemployment, a form of labor market slack that is likely to be especially elevated given the nature of the current economic shock. EPOPs alone do not take into account this dynamic.

Setting The Evans Rule Thresholds With Appropriate Generosity

When FOMC first debated the Evans Rule in 2012, the 6.5% threshold for the unemployment rate was aggressively contested. Some FOMC members saw the urgency of accommodative policy because unemployment was so elevated. Others were of the belief that structural unemployment had subsequently increased due to a variety of other factors and thus the Fed should withdraw some of its historic accommodation.

Calibration Strategy #1: Back To the Pre-COVID-19 Labor Market

If the Fed proceeds with a reformulated Evans Rule, then the initial calibration of the rule should not assume that structural unemployment or trend productivity growth have meaningfully shifted.

Demand-based thinking might be seen as the dominant flavor of the day, but supply-side narratives about recessions tempt policymakers as well. Philadelphia Fed President Charles Plosser saw the primary problem as one of mismatched skills within the labor force relative to the needs of society. Richmond Fed President Jeffrey Lacker even went so far as to claim that drug use and generosity of unemployment benefits were the primary causes of elevated unemployment in 2011. That the unemployment rate ultimately reached a low of 3.5% without aggravating sustained inflation shows how misguided this thinking proved to be.

Even some of the more dovish members of the FOMC were guilty of similar thinking with respect to productivity growth. Despite the absence of inflationary pressures, FOMC members extrapolated from recent productivity data to claim that wage growth was justifiably stunted. With the strong caveat that productivity data is very noisy and distorted, the final years of the 2010s expansion generally saw productivity accelerate to its fastest pace since the initial phase of the expansion when jobs were still being lost.

The purpose of a reformulated Evans Rule should be to recover the labor market that preceded the onset of COVID-19, when the prime-age 25–54 employment-to-population ratio was above 80% and the employment cost index was growing at approximately 3% year-over-year. While it is possible that there are structural shifts that complicate the achievement of those goals, it will be some time before we can do more than speculate. In the absence of such shifts, recovering the labor market of the fourth quarter of 2019 should be the Fed’s primary goal.

Prior to the onset of this pandemic, the economy was not suffering from overheating. If anything, the systematic under-performance of inflation and wage growth suggested that monetary policy could continue to err on the side of accommodation.

Calibration Strategy #2: Dynamically Revising Thresholds

At the risk of solving for suboptimal choices, if the Fed initially sets more conservative goals than what is suggested above, then it should be willing to dynamically revise those goals if more progress appears achievable. For example, if wage growth and price inflation fail to accelerate even as labor utilization rises, then the Fed should strengthen its forward guidance by setting more ambitious goals for labor utilization.

Revising the labor utilization threshold was an obvious remedy to the flaws intrinsic to the original Evans Rule. At the December 2012 FOMC Meeting when the Evans Rule was implemented, the unemployment rate was 7.7% and inflation was still running below its recently-adopted 2% target. But even as the Evans Rule was announced, flaws with the unemployment rate as a labor utilization gauge were emerging.

Much of the decline in unemployment that occurred over the course of 2013 was driven not by faster hiring but by a reclassification of the unemployed into labor force non-participants. With current knowledge of just how blurry these boundaries actually are, the ideal remedy would have been to switch to a better measure of labor utilization like the prime-age employment-to-population ratio.

As a second-best remedy, the FOMC should have been willing to move the goalposts, since the hollowing out of labor force participation was not actually proving to be inflationary. Declining unemployment at the expense of labor force participation was not providing us with any price signal to suggest a seriously tight labor market. Throughout 2013, core and headline inflation readings remained stable and below the Fed’s 2% inflation target while the employment cost index was still growing at less than 2% year-over-year. Beginning in September 2013, FOMC members began to continuously, albeit slowly, revise down their estimates of the natural rate of unemployment. However, in spite of these revisions, the Committee maintained its 6.5% unemployment threshold for defining the conclusion of state-based forward guidance for ZIRP.The confluence of these phenomena should have motivated the Fed to revise the Evans Rule unemployment rate threshold below 6.5%.

Chair Powell has recently admitted that the Fed had systematically underestimated the scope for how much labor market progress was feasible without aggravating inflationary pressures. Despite this awareness, the FOMC remains slow to adjust to changing information about the state of the labor market. If the Fed chooses to adopt more conservative thresholds, then it should at least be willing to revise such thresholds reasonably swiftly. The prior expansion should be instructive in this regard; higher labor utilization and wage growth were not associated with sustained above-target consumer price inflation.

Conclusion

While the Fed does face some constraints on its ability to affect the economic trajectory, it nevertheless still has power to support the economy and should exercise that power to foster a quick and full recovery from this public health and economic crisis. During the last three recessions, it took several years for labor utilization to stop declining generally, and still more to see something resembling a full recovery from the employment losses of the recession. It would be both a fiscal and monetary policy failure to see yet another sluggish recovery following the resolution of this pandemic. To that end, we suggest these six improvements to the Evans Rule as the Fed considers the merits and structure of state-based forward guidance:

1. Replace the focus on price inflation projections with an emphasis on achieving nominal wage growth as measured using the employment cost index for compensation or wages & salaries.
2. Floors, not ceilings: the Evans Rule’s ceiling threshold for projected inflation should instead be applied as a floor threshold, and preferably with respect to wage growth instead of consumer price inflation.
3. The labor utilization threshold should be a necessary “level target” condition and not an individually sufficient condition for ending state-based forward guidance.
4. Choose a more robust measure of labor utilization than the U-3 unemployment rate. The prime-age 25–54 employment-to-population ratio and Ernie Tedeschi’s demographically-adjusted NPOP measure would both be superior to the U-3.
5. Initially presume against “structural” shifts when calibrating forward guidance thresholds. The most appropriate thresholds for recovering the labor market are a 3% floor threshold for wage growth and a 80.3% floor for the prime-age 25–54 employment-to-population ratio.
6. Revise the thresholds dynamically in the face of new information about labor market progress.

While the Federal Reserve (Fed) cannot unilaterally deliver a swift recovery from the COVID-19 economic recession, it can still play a useful supporting role through its commitment to keep interest rates low. The Fed faces the same zero lower bound (ZLB) constraint that it faced in 2012, when it first decided to define its forward guidance policy for keeping interest rates low in terms of quantitative thresholds for economic indicators. At the December 2012 Federal Open Market Committee (FOMC) meeting, the Fed defined its commitment to zero interest rate policy (ZIRP) not in terms of a fixed calendar date but in terms of achieving specific macroeconomic benchmarks. In what is now known as the Evans Rule, the Fed committed to keeping interest rates low for as long as the unemployment rate remained above 6.5% and projections of inflation did not exceed 2.5%.

While the Evans Rule was not without its share of flaws, this quantitative state-based approach to forward guidance was a policy success. The commitment to keep interest rates low helped keep the economy afloat, despite headwinds from fiscal policy and household risk aversion. Future posts will discuss some of the flaws with and potential improvements to the Evans Rule that are relevant to our current context.

The Power of Forward Guidance: How The Fed Affects Interest Rates & Financial Conditions

The federal funds rate is the interest rate at which depository institutions lend and borrow reserves from each other on an unsecured basis. The Federal Reserve targets this interest rate through temporary and outright purchases of Treasury securities. By targeting the federal funds rate, the Fed manages to have comparable influence over other major short-term dollar-denominated interest rates as market participants seek to minimize arbitrage opportunities.

Yields on U.S. Treasury securities are especially sensitive to the expected path of the federal funds rate because the Federal Reserve conducts the vast majority of its open market operations through U.S. Treasury securities. 3-month Treasury yields closely track the interest rates on 3-month interest rate swaps that are indexed to each day’s federal funds rate.

While the federal funds rate directly affects other short-term interest rates, longer-term interest rates are more relevant for driving economic activity. The 30-year fixed rate mortgage is still the predominant financing vehicle for purchasing a home. Weighted average maturity of corporate bond issuance is typically over 15 years.

Yet changes in short-term interest rates do not automatically lead to consistent changes in long-term interest rates.

If the Fed signals that its change to the federal funds rate is a temporary measure to be reversed at a later date, then longer-term interest rates are less likely to change. In such instances, the yield curve steepens even when the Fed is cutting short-term interest rates. Likewise, the yield curve flattens (or even inverts) when the Fed raises short-term interest rates. Long-term interest rates can even move in the opposite direction of short-term rates if the market anticipates economic conditions that would motivate the Fed to ultimately reverse course.

As a result, the strength and credibility of the Fed’s guidance to market participants about the future path of the federal funds rate can be critical for influencing aggregate demand.

Conventional asset pricing theory tells us that long-term Treasury yields are largely a function of the expected path of short-term Treasury yields over the same time horizon, plus (or minus) an additional premium that compensates investors for the associated riskiness of holding higher duration Treasury securities. Since yields on short-term U.S. Treasury bills track the federal funds rate closely, market participants’ expectations for the future path of the federal funds rate should be reflected in yields on longer-term U.S. Treasury securities.

Forward guidance can help to clarify the expected path of short-term interest rates and limit the variance of potential outcomes in the process. If the Fed makes a credible commitment to maintain ZIRP for the next two years, then in the absence of any additional risk premium, 2-year U.S. Treasury Notes should also reflect the same ~0% yield as short-term Treasury Bills.

Now if 2-year U.S.Treasury Notes already reflected the expectation that the Fed would maintain ZIRP for two years, the Fed providing an explicit 2-year commitment to ZIRP would have very little additional effect. Moreover, calendar-based commitments do not provide additional clarity about the macroeconomic outcomes the Fed is seeking to achieve through ZIRP.

If the Fed could credibly commit to ZIRP as long as the unemployment rate remained above a specified level, then market participants would price ZIRP into the Treasury yield curve for as long as they expected the same outcome. If market participants later revised down their expectations of growth, market pricing would simultaneously adjust to reflect a longer timeline for ZIRP. As a result, there would be less of a need for the Fed to inject updated views about the expected timelines associated with their policies.

Theory vs. Practice — The Evolution of Forward Guidance Following The Great Recession

When the Federal Open Market Committee (FOMC) first voted to lower interest rates to the ZLB in December 2008, it signaled a qualitative calendar-based approach to forward guidance, committing to keep rates exceptionally low “for some time.” “For some time” soon morphed to “for an extended period” at the March 2009 FOMC meeting. Yet such guidance was largely meaningless because as soon as riskier assets formed a sustainable trough, markets began anticipating interest rate increases and Chair Bernanke was already willing to start advocate for fiscal tightening!

Ben Bernanke urged Congress on Wednesday to act now to bring down long-term budget deficits, warning that a failure to do so might lead to a future debt trap. The Federal Reserve chairman said the recent sharp increases in bond yields “appear to reflect concern about large federal deficits” as well as improved optimism about the economy and other factors.

Since late April, the yield on the 10-year Treasury note has risen from below 3 per cent and peaked at 3.76 per cent last week, its highest level since November. Mr Bernanke said large deficit-funded actions to fight the crisis were “necessary and appropriate”.

But he said “near-term challenges must not be allowed to hinder timely consideration of the steps needed to address fiscal imbalances”.

At the time that Chair Bernanke delivered those comments, job losses were still mounting and the Fed’s own projections of the unemployment rate suggested that interest rate increases would necessarily be much further out in time. In retrospect, this was a missed opportunity for pro-actively offering clearer forward guidance. Only at the August 2011 FOMC meeting, after the economy was already in the midst of a slowdown, did the Committee replace its vague qualitative guidance for calendar-based guidance by committing to keeping the federal funds rate near the ZLB “at least through mid-2013.”

The major problem with these forms of forward guidance was that it was unclear what objectives the Fed was ultimately seeking to achieve. In light of the risks posed by fiscal policy tightening and an ongoing set of sovereign debt crises in the Eurozone, the Fed was regularly forced to extend its timeline for ZIRP. It was far from clear to what extent the changes in calendar-based forward guidance reflected more ambitious policy objectives or simply a re-calibration of policy settings in response to negative economic developments.

Given The Circumstances, The Evans Rule Was A Success

Only in December 2012, amidst uncertainty about the paths fiscal policymakers might take, did the FOMC move away from calendar-based forward guidance and instead issue state-based forward guidance. At that meeting, the Fed defined the timeline for ZIRP according to quantitative economic thresholds:

at least as long as the unemployment rate remains above 6–1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well-anchored

These thresholds became known as the Evans Rule and served as the guide for Fed policy through to March of 2014, when the unemployment rate finally fell below 6.5%.

At first glance, it is tempting to say that this policy change did little to affect the trajectory of the US economy. The US economy grew slowly before, during, and after the period during which the Evans Rule was in effect. Moreover, communication errors and misperceptions about the Fed’s asset purchase policy in this period resulted in a historic bout of Treasury market volatility during the “taper tantrum.”

These points of skepticism have some validity but should not be lost in the broader context of the moment. Households were still working through a historic debt overhang with consumption growth still showing signs of lingering weakness. After years of historically low household saving rates in the late 1990s and the 2000s, the housing bust and Great Recession precipitated a rising propensity for households to save and strengthen their balance sheets. That said, the 2012 surge in the saving rate was the result of a temporary dynamic in which the fiscal cliff motivated the acceleration of dividend payouts that inflated measures of household income.

In addition to weak household consumption growth, the federal government was veering towards more fiscal austerity, hardly ideal when labor utilization is depressed and a private sector still deleveraging from the wounds of the housing bust and the Great Recession.

Despite all of these headwinds from late 2012 to early 2014, the US growth outlook somehow brightened. Though declining labor force participation exaggerated the effect, employment growth was nevertheless steady.

The core dynamic that shifted over this period was greater investment appetite within the corporate sector. Corporate credit and equity risk premiums continued to compress from late 2012 to mid-2014 in spite of the short-term surge in Treasury yields during the mid-2013 “taper tantrum.” The “taper tantrum” did reflect some excitement about the Fed ending its asset purchase policy sooner and possibly a faster liftoff from the ZLB, but at no point was it seriously expected that the Fed would make such an aggressive exit that it would jeopardize the objectives reflected in the Evans Rule.

While compressing corporate credit and equity risk premiums do not consistently lift growth and investment, in 2012–14, the upswing in business fixed investment was critical for offsetting aggregate demand headwinds.

Even though the Great Recession technically ended in 2009, the process of deleveraging within the household and financial sectors during and following the financial crisis meant that other sectors would need to carry the burden of generating sufficient aggregate demand. Yet with the fiscal cliff looming large at the end of 2012 and austerity policies already in train, the set of economic actors capable of supporting income growth within the rest of the economy was especially narrow. The US was closer recession than might otherwise be appreciated in retrospect. Fortunately, the non-financial corporate sector accelerated its rate of spending and investment to buffer the rest of the economy.

While the Evans Rule did not cause this outcome directly in the way that fiscal expansion could have, the Fed’s unconventional policies still helped to preserve the business cycle expansion amidst significant obstacles.

• The pricing of the Municipal Liquidity Facility (MLF) makes it virtually irrelevant for most municipal debt issuers because current market prices are well above those that the Federal Reserve (Fed) is offering. The success or failure of the MLF should be judged not solely by current municipal bond yields, but whether the facility serves to catalyze more issuance. Municipal bond issuance has slowed down in the past three months. In the absence of additional debt issuance or federal aid, the odds of aggressive state and local government austerity is only going to rise further.
• State and local government deficits are inevitable when the private sector retrenches in order to run larger surpluses. Yet because of balanced budget requirements, these governments typically undertake aggressive cuts to employment and investment to cope with such deficits. As a result, economic downturns are exacerbated and recoveries proceed slower. The ideal solution to this problem is direct, automatic aid to fill revenue shortfalls.
• While borrowing is second-best to direct fiscal aid, it can nevertheless serve as a gap-filling measure that supplements the primary solution of direct, automatic federal aid. Congress should therefore authorize the creation of an external entity backed by the U.S. Treasury that can borrow on behalf of state and local governmental entities. While these state and local officials would be able to direct borrowed funds to as needed to preserve employment and investment during economic downturns, the debt would ultimately be backed by the U.S. Treasury. This would simultaneously overcome challenges posed by municipal balanced budget requirements, while increasing the likelihood that the Fed would purchase such debt as part of its authority to conduct open market operations.

So Much For The Fed Using Its Lending “Cannon”…

The main problem with the MLF is pricing.

The CARES Act gave the Fed authority to lend to a variety of different entities it is not typically authorized to lend to, including non-financial corporations and municipalities. The purpose of delegating such authority was to “provide liquidity,” presumably to help the many businesses and municipalities that were going to face substantial financing gaps amidst historic declines in revenues and incomes.

After much hype about the Fed’s bold steps to create and expand the Municipal Liquidity Facility (MLF) to reach lower-population cities and counties, the latest iteration of the facility’s parameters have been disappointing. The pricing and available maturity for financing through the MLF is especially stingy when compared to what the Main Street Lending Program offers to levered businesses of significantly weaker credit quality.

Instead of serving as an active lender to state and local governments, the Fed’s stiff pricing terms make the MLF only relevant as a “broad-based” facility in a period of extreme financial market turmoil. Anything short of such historic extremes will limit the usefulness of the facility for the vast majority of municipal bond (“muni”) issuers, and especially those with stronger credit ratings.

Only the sliver of governments that are vulnerable to being downgraded into a “junk” credit rating below investment grade are likely to access the MLF based on recent market conditions.

Current asset prices are only useful if they draw out more issuance

Since municipal securities are not typically part of the Fed’s regular open market operations, their issuers, unlike the U.S. Treasury, must be more wary of the effects of additional issuance on their ultimate cost of borrowing. New issuance needs to find new buyers and that usually results in the issuer making price concessions. If the Fed were to make more consistent purchases in the municipal bond market, it could significantly mitigate this dynamic.

Given the Fed’s mandate from Congress to pursue “maximum employment” and the number of public sector jobs hanging in the balance, the Fed should be judged by its ability to catalyze more muni issuance; current asset prices do not tell the entire story. The recent trends in muni issuance suggest that treasurers are getting less confident about their capacity to issue. After a strong start to the year, issuance has slowed back down to the five-year average, even though municipal yields have fallen over that same timeframe.

State and Local Government Deficits Are Inevitable. Federal Transfers Should Be The Primary Solution

The inevitability of government deficits should be an obvious fact of macroeconomic accounting, but the laws of most state governments fail to grasp this arithmetic reality. Elected officials are often no better.

For every dollar of income an economic actor earns in excess of its expenditure, another actor must be running a countervailing dollar of deficit. Recessions are typically marked by the private sector’s propensity to save more by cutting expenditures relative to incomes. This inevitably leads to (larger) government deficits. Unfortunately, through constitutional and statutory balanced budget requirements (BBRs), state and local governments have straitjacketed themselves into a position where they are forced to cut public services and employment at the very moment the private sector retrenches. When tax revenues fall, these governments are often mechanically compelled to raise taxes and cut expenditures to maintain balanced operating budgets, thereby cannibalizing their existing revenue base. The ability to deficit-finance can play an especially helpful role in preserving and increasing employment (Carlino and Inman, 2013).

If revenue shortfalls could be perfectly anticipated ahead of time, direct transfers from the federal government would be sufficient to overcome any of the statutory or constitutional BBRs that these governments typically impose on themselves. Indeed, the vast majority of lost revenue in a recession should be filled through a straightforward and automatic formula for direct transfers. Please see Alexander Williams’ proposal for how the federal government could set up a direct transfer mechanism to aid state and local governments in economic downturns.

Congress Should Create Municipal Borrowing Vehicles To Preserve Employment In Downturns

While direct aid to states is ideal, no formula will be perfect across all municipalities. There will be still be gaps between revenues and expenditures that, in the absence of additional borrowing capacity, is likely to result in austerity policies that exacerbate economic downturns. While balanced budget requirements and debt issuance limitations constrain municipalities from solving this problem directly, the federal government can offer a comprehensive solution.

Federal-State Hybrid Entities Can Overcome The Obstacles Posed By Balanced Budget Requirements

The federal government already makes its balance sheet available to external entities in a variety of ways. The Development Finance Corporation provides private businesses operating overseas loan guarantees, debt financing, and equity financing. The Unemployment Trust Fund provides state governments a vehicle for borrowing funds (independent of the state government’s balance sheet) for paying out federally mandated unemployment compensation.

A variety of financing and administrative models are possible provided that (1) municipalities retain some control in determining where the borrowed funds are directed and (2) the liability ultimately rests on the balance sheet of the U.S. Treasury, or at least not the balance sheet of the municipality. This avoids the potential conflict with municipal BBRs. In an ideal world, these BBRs would be more flexible during broader macroeconomic downturns, but since they are often constitutionally codified, they are unlikely to change in the near-term.

Such borrowing vehicles should still be subject to the condition that they are used for equitably and efficiently preserving employment and investment during a cyclical economic downturn. A municipality seeking funds must also provide evidentiary basis that it is suffering from revenue shortfalls that were caused by a cyclical economic downturn either at the state or national economic level. If those conditions are met, then the federal government can credit the vehicle with the necessary funds to be directed for the municipality’s specified use.

Financing Backed By The U.S. Treasury Would Increase The Fed’s Willingness To Engage and Support State and Local Governments

Aside from overcoming BBRs, Treasury-backed borrowing vehicles would come with the added benefit of giving the Fed additional comfort with purchasing the securities associated with such borrowing. It is precisely because of the Treasury’s status as ultimate guarantor that the Fed has disproportionately engaged in the market for mortgage-backed securities issued by government-sponsored enterprises.

While there is no statutory requirement that the Fed turn a profit for the Treasury, the Fed chooses to avoid running a loss on its balance sheet out of a sense of political pragmatism. By making the U.S. Treasury the ultimate loss-absorber, Congress would empower the Fed to purchase such debt using its authority under Section 14 of the Federal Reserve Act (Open Market Operations).

It should be reiterated that this program is not intended as a substitute for direct aid to state governments. It is a supplementary gap-filling program that remedies the traditional problem of federal aid coming a day late and a dollar short of what’s usually needed. Even if Congress implemented state aid as an automatic stabilizer triggered by transparent macroeconomic data, no formula or trigger for filling lost tax revenue will be perfect across all governmental entities. To prevent such entities from holding the bag in such a scenario, it would be prudent to have a foolproof mechanism for ensuring that they are able to address desperate expenditure needs in the midst of macroeconomic downturns.

State governments are on the front line of the COVID-19 pandemic and its economic fallout. In the coming weeks, they will be subject to increasing demands to expand healthcare capacity and support existing initiatives, all while tax revenue dries up and financial market turbulence freezes the municipal bond market. The Federal Government has begun to respond to this challenge by increasing Medicaid funding and issuing $50 billion in additional funds for public health initiatives. Nevertheless, the pace of the Federal response remains slow and local funding needs are still at risk of going unmet.

The Fed Should Immediately Commit To Support Short-Term Financing For State Governments

We are calling for the Federal Reserve (“Fed”) to exercise its existing authority under Section 14(2)(b) of the Federal Reserve Act to immediately commit to purchasing short-term municipal debt securities (“munis”) as is necessary to (1) stabilize all state government funding needs and (2) provide them with the appropriate financial flexibility to address the present public health crisis.

• The Fed can commit to this policy immediately, unlike other types of Fed interventions that require additional approval from the Secretary of the Treasury.
• If the Fed committed to making such financing available to state governments, it would influence market conditions instantaneously, even if full implementation required additional time.

Previous proposals have highlighted the value of exercising and expanding the Fed’s authority to support state and local governments (Konczal, Mason 2017). Our proposal provides a roadmap for how the Fed can design a funding facility to help state governments directly address the current crisis with existing statutory authority under the Federal Reserve Act. No additional legislative or executive action is required to enact our proposed policy.

Extending the Privilege of the Federal Government to State Governments

The Federal Reserve controls the quantity of reserves within the regulated financial system through temporary and permanent purchases and sales of United States Treasury debt securities (“Treasuries”). This ensures that the Treasury market remains liquid in both good times and bad. As a result, the Federal Government can use its balance sheet elastically to raise the necessary funds to overcome virtually any nominal balance sheet constraint (not to be confused with real resource constraints). Generally speaking, the more financial turbulence and risk-aversion that exists, the greater the flight to liquid assets. This dynamic results in lower yields on Treasuries and the associated cost of borrowing for the Federal Government.

The Federal Reserve has been historically reluctant to extend such privilege to state governments. In periods of volatility and illiquidity across major asset classes, such as what we are witnessing today, munis are not immune. When market conditions become so highly correlated across asset classes, even the most prudent financial actors can be locked out of access to financing. This is especially true in periods of high economic uncertainty. On March 12, 2020, the municipal bond market experienced conditions that were reported to be “worse for the market than the aftermath of September 11th and the 2008 financial crisis,” with AAA-rated municipal debt trading at historically high yields relative to the 10-year U.S. Treasury Note.

State and Local Government Spending Has Been Highly Pro-Cyclical

A disruption to municipal bond markets will have dire effects on the economy at a time when states need to be ready to fight the COVID-19 epidemic. In 2019, state expenditures made up more than 40% of government spending, which in turn makes up more than a third of GDP. State spending has funded up to 72% of infrastructure investment spending since 1996.

Shrinking state budgets offset much of the benefit of the 2009 American Recovery and Reinvestment Act (ARRA) fiscal stimulus during the Great Recession. When the funds from ARRA allocated to state and local governments dried up, we subsequently saw these governments sharply cut back on spending and increase layoffs.

The Statute Is Clear: The Fed Can Purchase Short-Term Muni Debt

Under section 14(2)(b) of the Federal Reserve Act, the Fed has the authority to:

“To buy and sell, at home or abroad, bonds and notes of the United States, bonds issued under the provisions of subsection (c) of section 4 of the Home Owners’ Loan Act of 1933, as amended, and having maturities from date of purchase of not exceeding six months, and bills, notes, revenue bonds, and warrants with a maturity from date of purchase of not exceeding six months, issued in anticipation of the collection of taxes or in anticipation of the receipt of assured revenues by any State, county, district, political subdivision, or municipality in the continental United States, including irrigation, drainage, and reclamation districts, and obligations of, or fully guaranteed as to principal and interest by, a foreign government or agency thereof, such purchases to be made in accordance with rules and regulations prescribed by the Board of Governors of the Federal Reserve System.”

The statute makes clear that the Fed has the authority to provide short-term financial support to state and local governments. Indeed, the most basic historical function of central banking is to ensure that the critical short-term financing needs of the sovereign are met in a time of crisis. The evident purpose of Section 14(2)(b) is to enable the Fed to lend directly to any entity of the federalist system to achieve its broader objectives.

Section 13(3) of the Federal Reserve Act, gave the Fed broad license to intervene in virtually any market during an emergency, but since the passage of the Dodd-Frank Act, such emergency measures must receive direct approval from the Secretary of the Treasury. Section 14(2)(b) is not subject to such restrictions and thus allows the Fed to take unilateral action today to provide states with a direct avenue to short-term financing.

Using the Fed’s Crisis Facilities As A Model

Prior Fed lending facilities during the Global Financial Crisis (“GFC”) offer a clear model of how the Fed can support state governments as they seek to make critical expenditures and investments in a time of crisis. The Commercial Paper Funding Facility (“CPFF”) was established on October 27, 2008 to purchase unsecured and asset backed commercial paper (“CP”) of maturities no more than three months. The facility was kept open through February 1, 2010, well after the recession officially ended and credit markets had normalized. The CPFF was remarkably effective in restoring liquidity for businesses that relied on CP markets to access affordable financing. If these businesses were not able to refinance affordably, ongoing market dysfunction would have surely led to even more layoffs and bankruptcies.

The CPFF’s successful provision of liquidity to businesses in the GFC makes it a model for establishing a short term, emergency muni funding facility. A short-term funding facility will allow state governments to ride out the COVID-19 pandemic and its associated market dysfunctions. Market turbulence did not begin with muni markets, but it now seems to be having a uniformly constraining effect across all issuers, regardless of their underlying financial health. Sales tax collections and other state-level revenue generators are likely to decline for virtually all governments as economic activity takes a hit. Without the same degree of working capital or stable lines of credit that are typically available to private sector entities, state governments are more likely to be forced into making sharp expenditure cuts if financial markets freeze up for a sustained period.

The Fed should make this facility temporarily available for at least twelve months after the associated economic impact of COVID-19 reaches its peak. This is already a significant enough crisis in terms of how it will test the capacity constraints of public health systems across the country. State governments should not have to simultaneously worry about financial market collateral damage depleting increasingly scarce fiscal resources. The Fed’s facility will ensure that state governments can easily roll over debt and meet their funding needs throughout the COVID-19 crisis by relieving some of the stresses weighing on the secondary muni market.

A Fed facility that was directly parameterized to the scale and timeline of the COVID-19 crisis would also short-circuit the pernicious pro-cyclicality of state laws that, to varying degrees, mandate balanced budgets. These laws encourage penny-pinching at the first sight of falling sales tax collections, even though the current moment should actually be spurring state governments to think ambitiously about how to address the current challenge and invest in new capacity. It is already a well-established practice that federally supported programs are not counted for states’ balanced budget requirements. Capital expenditures that can be backed by future revenue streams are similarly discounted. If necessary for maintaining the commitment to structurally balanced budgets, the Fed’s support should extend to state-owned public health corporations that are specifically dedicated to expanding hospitals and other public health infrastructure.

Considerations and Concerns

On first glance, these types of measures may seem extreme because of the absence of a recent precedent. However, in this pressing emergency, state governments bear the major financial cost associated with on-the-ground interventions to treat and prevent the spread of communicable diseases. Logistically speaking, were it not for their budget and financial constraints, they are arguably in the best position to allocate expenditures for expanding the capacity of our public health system. To guarantee that state governments make the necessary investments during this trying time, all institutions of the Federal Government should, within their statutory authority, play their appropriate supporting role.

Some critics might balk at taking such actions given the supposed difference between monetary policy and fiscal policy. To reiterate, the statute is quite clear that the Fed is already authorized to support the flow of certain types of financing to state and local governments. Presumably this power is of greatest importance in times of crisis. In 1933, during the height of the Great Depression, the Fed held 1,493 thousand dollars of municipal warrants, up from 120 thousand in 1927.

Some might be uncomfortable with extending the credit facility for a period that extends beyond the maturity limit specified in 14(2)(b). The CPFF is a clarifying analogue: the CPFF allowed the rollover of shorter-term 1-month and 3-month commercial paper for nearly 16 months on a timeline that covered some of the most challenging phases of the GFC. A similar commitment now would not only serve to calm financial markets, but would also enable states to have the confidence to calibrate their spending to what the public health crisis calls for, not what financial markets capriciously demand.

Coordinating a program with fifty state governments might seem like a daunting challenge for the Federal Reserve System. However, there are twelve regional reserve banks that should already have existing relationships with state treasurers. The decentralized structure of the Fed should alleviate this coordination problem and ensure that a responsive effort can take place swiftly.

The COVID-19 pandemic presents us with a major public health and economic challenge. While doctors, hospitals, nurses, and public healthcare workers struggle to contain the virus and treat the ill, central bankers should be doing all that they can to ensure that arbitrary financing constraints do not hinder the necessary response.

The impact of COVID-19 is likely to be sizeable. Regardless of the precise composition of the shock to supply and demand, further macroeconomic policy action is now necessary. The Fed can cut the benchmark Federal Funds Rate a few more times, but only Congress and the White House can provide a surefire solution that prevents the short-term impact from COVID-19 from causing more persistent damage to employment and incomes. The current predicament also provides an opportune moment to pass permanent enhancements to automatic stabilizer programs so that fiscal policy can adjust dynamically to changes in recession risk, whether they stem from COVID-19 or otherwise.

Summary

• Judging by the accelerating spread of COVID-19 and its corresponding effects on major economies and financial markets, fiscal stimulus is likely necessary if the economic costs are to be contained. We will never know the precise decomposition of the impact between “supply” and “demand,” but COVID-19 is a substantial income shock for many households and businesses. Without macroeconomic policy buffering against such income shocks, financial constraints are more likely to bind and risk setting off a vicious cycle of layoffs and bankruptcies.
• The Fed has been the primary institution for managing macroeconomic policy, but it now has limited ability to unilaterally support demand. Short-term interest rates can only be lowered a few more times. Long-term interest rates are so low that asset purchases (LSAP / QE) and forward guidance are of little affirmative value. That said, the low level of government borrowing costs should also provide a powerful price signal to Congress and the White House: now is the time to err on the side of borrowing and investing aggressively to avoid future economic losses. The benefit of avoiding nasty spillover economic costs in the private sector would outweigh the marginal cost associated with additional government borrowing.
• With supportive and flexible macroeconomic policies, economic activity can rebound sharply from COVID-19, just as it does from natural disasters. A number of policies are likely to help in the current context: ensuring that impacted small and medium businesses have sufficient access to low-cost loans as is typically done through the Small Business Administration in natural disasters, direct payments to households similar to the Economic Stimulus Act of 2008, and some of the proposals already suggested in Jason Furman’s recent op-ed: expansion of Medicaid and public health funding for state governments, paid sick leave, and extensions to unemployment insurance.
• Given the unknown scope and scale of the fallout from COVID-19, there needs to be some degree of contingency planning underlying a fiscal response so that it can be appropriately scaled to scenarios in which the impact is both better and worse than currently expected. The ideal outcome is for fiscal policy look a lot more like the automatic stabilizer programs that have already been proposed in Recession Ready. Such programs rely on Congress preemptively authorizing stimulative measures so that fiscal policy can respond quickly enough to changing conditions. If Congress were to pass such enhanced automatic stabilizer programs, this would also help to diminish concerns associated with the Fed’s capacity to fight recessions when interest rates are already so close to the zero lower bound. Regardless of the source or timing of recession risk, automatic stabilizers enable fiscal policy to play a more a reliable role in insuring against recessionary outcomes.

COVID-19 and Low Interest Rates Make Fiscal Stimulus And Enhanced Automatic Stabilizers A No-Brainer

The Case For Macroeconomic Policy Action

As we continue to re-evaluate the health effects associated with the spread of COVID-19, macroeconomic policymakers in the United States need to pay correspondingly close attention to its effects on financial markets and major economies. Without an appropriate evaluation and response to these effects, a temporary shock to business revenues and individual wages can easily snowball into something much larger, persistent, and potentially recessionary.

Econ 101 has led to some anxiety about whether macroeconomic policy can even do much in this environment. Isn’t a virus that prevents individuals from working and factories from running a “supply” shock that “demand-side” fiscal policy can’t do much about? Austan Goolsbee argued recently in the New York Times that perhaps it is a demand shock after all:

So for all the talk about the global “supply shock” set off by the coronavirus outbreak and its impact on supply chains, we may have more to fear from an old-fashioned “demand shock” that emerges when everyone simply stays home.

The truth is we will never know, especially in real-time, how much of this economic impact is strictly about “supply” or “demand,” but it is quite clearly an income shock. The loss of income for private sector actors needs to be seen not just in terms of resource constraints, but also in terms of financial constraints. In the private sector, lost income can quickly lead to spending cutbacks that directly affects the incomes of others. The spillover costs can be large because of a lack of private sector financial capacity, even if the economy has the resource capacity. This is precisely what macroeconomic policy is best-suited to resolve and prevent. By buffering the incomes and revenue streams of households and businesses, macroeconomic policy can quickly short-circuit the vicious cycle of layoffs and bankruptcies.

With Interest Rates Already So Low, Fiscal Policy Is Clearly Superior To Monetary Policy

The Fed has been the conventional institution for managing macroeconomic policy, but with interest rates already historically low, it has little room left to unilaterally support credit and income growth. Short-term interest rates can only be lowered a few more times; the Federal Funds rate is just 1% above what it defines as the “effective lower bound.” The Fed’s large scale asset purchases (LSAP, aka “QE”) of Treasury securities and forward guidance about the future path of the Federal Funds Rate are also of little affirmative value now. Long-term interest rates are already so low that the slope of the yield curve cannot be flattened much further. Long-term Treasury yields are lower now than they ever were during the global financial crisis or this ongoing business cycle expansion.

The low level of government borrowing costs is a challenge for unilateral monetary policy, but in the context of macroeconomic policy as a whole, it is a historic opportunity. The government is not equivalent to the private sector, but if it were, the signal from Treasury yields is that now is the time for the Federal Government to borrow and invest aggressively to preserve future economic growth.

“V-Shaped” Rebounds Remain In Grasp But They Need Supportive Policies That Sufficiently Counteract The Scale Of The Shock

Economic activity is likely to be depressed for a temporary period as supply chains are forced to adjust to the impact of COVID-19. Risk-mitigation efforts could also have out-sized effects within the services sector, as businesses and workers are forced to postpone activity and reduce their hours. The human costs of this alone are significant, but it would be all the worse if businesses are forced to shed jobs and cut investment due to the lack of adequate financing options. Similarly, we don’t want workers facing lost hours and incomes to be forced to curb their consumption more aggressively for what should otherwise prove to be a temporary phenomenon. However, if we fail to address the risk of such a vicious cycle, this fundamentally “temporary” phenomenon can have more persistent effects on the current economic expansion.

While the uncertainty and persistence associated with the impact of COVID-19 is of a much larger magnitude than the typical natural disaster, with the appropriate policies in place, a “V-shaped” economic rebound still remains feasible. Without such policy support, the vicious cycle of layoffs and insolvencies will be much harder to reverse. This in large part describes why recessions, despite being “temporary,” have increasingly coincided with multi-year “jobless recoveries.”

A number of policies are likely to help in the current context. While the Fed can still reduce short-term interest rates in the hope of lowering the discount rates associated with riskier financial assets, the Fed’s recent 50 basis point emergency interest rate reduction has not proven as effective for supporting financing conditions. For larger firms with more privileged access to capital markets, borrowing costs have continued to rise. The reality for small and medium-size firms, which already face more limited financing options, is likely to be even more challenging.

With the appropriate coordination across the Fed, the Secretary of the Treasury, and Congress, low-cost financing could be made available to businesses regardless of their size. Due to the “unusual and exigent circumstances” of the financial crisis, the Fed had the authority to create the Commercial Paper Funding Facility, which allowed it to lend directly to larger firms via the short-term commercial paper market. Following the passage of the Dodd-Frank Act, the Fed’s authority to take such action under Section 13(3) of the Federal Reserve Act now comes with the added requirement of approval from the Secretary of the Treasury. Even if the Fed did something similar now with Treasury approval, such a facility would not necessarily reach smaller firms directly. In natural disasters, Congress authorizes funding for the Small Business Administration to provide low-cost loans to such firms so that they can cover operating expenses, including payroll, during periods of temporary economic weakness. Congress should ensure that similar institutional capacity is made available for addressing the current economic shock.

In addition to broadening the direct provision of credit to businesses of all sizes, Congress and the White House should also be working to enact a variety of measures that can provide a targeted boost to households. Direct payments to all households, similar to the Economic Stimulus Act of 2008, can help ensure that temporary reductions in labor income do not translate into additional reductions in household consumption. Jason Furman’s recent op-ed in the Wall Street Journal included additional proposals that would be effective for targeting income where it is most likely to serve as a buffer. Expanding Medicaid and additional public health funding to all state governments would be especially effective since balanced budget laws make State governments inclined to cut spending when the economy is already weakening. Forcing States to penny-pinch their way through the current shock runs the risk of more substantial costs down the road if the impact of COVID-19 is not properly contained. The case for ensuring paid sick leave and extending unemployment insurance are equally compelling since the benefits would be directed to the most adversely effected individuals. These individuals would also be the most likely to make use of such income in a manner that further supported economic activity.

To Meet The Immediate And The Structural Policy Challenges, Congress Should Enhance Automatic Stabilizer Programs

Given the unknown scope and scale of the fallout from COVID-19, there needs to be some degree of contingency planning underlying a fiscal response so that there is an appropriate adjustment for better- and worse-than-expected scenarios. The ideal outcome is for fiscal policy to look a lot more like the automatic stabilizer programs that have already been proposed in Recession Ready. Automatic stabilizer programs mechanically increase government spending and reduce tax burdens as the economy weakens. Preemptive Congressional authorization for stimulative programs ensures that fiscal policy adjusts dynamically to the evolving impact of COVID-19. Otherwise, if each new development requires an additional iteration through the legislative process, urgent issues of macroeconomic and public health are likely to be slowed down and excessively politicized.

Enhancing automatic stabilizer programs would also go a long way to resolving the questions at the center of the Fed’s ongoing Review of Monetary Policy Strategy, Tools, and Communications. With short- and long-term interest rates already historically low and inflation continuing to run persistently below its 2% target, the Fed is particularly worried about its capacity to fight off a recession. If fiscal policy more reliably insured against recessionary outcomes, then much of the concern associated with monetary policy near its effective lower bound would also subside. Automatic stabilizers offer a robust solution, regardless of whether the precise source of recession risk is a financial panic, a deleveraging private sector, a natural disaster, or a pandemic.

The official national accounts estimate of gross labor income (GLI) is based on the Quarterly Census of Employment and Wages (QCEW), but because of sharp revisions to the QCEW data, it can take several quarters before we get stable readings. The Fed does not have the luxury of waiting for such data to be fully revised before coming to its decisions. The employment data from the Current Population Survey (CPS) and the wage data from the National Compensation Survey (NCS) can offer a clearer real-time view of GLI growth and thus bypass the challenges posed by revisions to the national accounts estimate.

In “Floor It! Fixing the Fed’s Framework With Paychecks, Not Prices,” I used the “Compensation of Employees, Received” series from National Income & Product Accounts Table 2.6 to show how gross labor income (GLI) growth and the Fed’s projections of GLI growth had evolved over time. While the conceptual consistency of the national accounts series has some advantages, the revisions to the series can be a major problem if the series is heavily relied upon for making real-time decisions.

National accounts data, especially GLI, can be revised aggressively, often for several quarters in retrospect. This makes it more difficult to take the most recently released national accounts data at face value. What you see with respect to GDP or GLI growth for a given quarter can look very different in later releases. The Current Population Survey (CPS) and the National Compensation Survey (NCS) can help cut through this problem by giving us estimates of employment and wage growth that are not subject to the same problem of revisions.

The CPS, also known as the “household survey,” gives us fairly reliable monthly estimates of employment growth and demographic structure on ‘Jobs Friday.’ There are minor revisions to the seasonal factors of CPS estimates but the underlying source data is not subject to revision. Similarly, the employment cost index (ECI), which is derived from the NCS, also avoids the issue of revisions that stems from the Quarterly Census of Employment and Wages (QCEW).

The Arithmetic Specification of Gross Labor Income (GLI)

GLI is the product of employment, compensation per hour, and the average workweek. While variations in the average workweek can matter around local time horizons, the vast majority of the variation in GLI growth reflects changes in employment and hourly wage growth. As a result, estimates of employment from the CPS and hourly wage growth from the NCS should be sufficient for developing a robust real-time tracker of GLI growth.

The Conceptual Derivation of the “Floor” Under GLI Growth

The specified “floor” for gross labor income growth can be conceptually decomposed into (1) an estimate of potential labor supply growth, (2) a baseline target for real wage growth, and (3) a baseline target for the rate of inflation.

Potential labor supply growth can be conservatively estimated from the data on population growth and demographic structure in the CPS. For a more aggressive definition of the “floor” (not specified here), labor market slack in the form of elevated unemployment and underemployment could also be taken into account. The long-term trend in productivity growth and the Fed’s 2% inflation target can be used for calibrating the other two components of the “floor” for GLI growth.

Tracking GLI Using Prime-Age 25–54 Employment and ECI

The growth rate of employment and population among prime working age adults (age 25–54) in the CPS can be used for deriving a quick estimate of how employment is growing relative to potential labor supply.

Likewise, the growth rate in ECI for compensation of private industry workers can give us a reliable real-time estimate of how wage growth is evolving relative to the long-term trend in productivity growth and the inflation target.

With these two estimates, we can derive a real-time tracker of GLI growth without having to go through the trouble of comparing revised and unrevised estimates of the “Compensation of Employees, Received” series.

How Prime-Age Employment and ECI Compare To The National Accounts

While the real-time GLI tracker has sometimes diverged from what the latest release of the “Compensation of Employees, Received” series now shows, the policy prescriptions implied by both series are generally quite similar. The lack of readily available archives for the national accounts series makes it more difficult to compare what the two series would have suggested to policymakers in real-time.

What The Real-Time GLI Tracker Has Been Telling Us Lately

In the summer of 2019, the prime-age 25–54 employment rate and the ECI for total compensation among private industry workers brought estimates of the real-time tracker of GLI growth below the conservatively defined “floor.” When coupled with the fact that financial conditions were signaling a growth outlook that hinged on Fed easing, the cuts of 2019 were probably appropriate.

Growth in ECI has yet to fully rebound, but we have seen a sharp rise in the prime-age employment rate over the past 5 months. This has helped to power the real-time GLI tracker back above the “floor.” Considering that financial conditions also suggest no major downside risks to the expected path of GLI growth, further easing does not appear necessary at this stage. Yet with core inflation continuing to run below the Fed’s 2% target, further tightening also appears to be unjustified. Until we see a clearer inflection in macroeconomic data or financial conditions, a Fed on hold remains quite reasonable.

Fed Communication Suggests Recognition Of A New Reality

Chair Powell’s recent statements reveal a fundamental shift in how the Fed communicates. At the June FOMC press conference, Chair Powell noted that “the reason why we say ‘sustain the expansion’ is [that]…communities… are being brought into the benefits of this expansion that hadn’t been earlier.” He reiterated this at his most recent Humphrey-Hawkins testimony:

“What we’re hearing…from people who work and live in low and moderate income communities is that…with this tight labor market, employers…are waving…issues that might have prevented people from being in the work force.”

Monetary policy is no panacea but its impact on how macroeconomic benefits are shared and maintained extends beyond the short run. With this knowledge, the Fed has an elevated responsibility to stay attentive to the risk of slower growth, even amidst a low headline unemployment rate.

Despite a mandate to pursue “maximum employment,” the Fed has generally preferred to set the bar much lower. Even as former Chair Bernanke sought justification for easier policy in the years following the financial crisis, he felt compelled to offer the following caveat:

“Monetary policy — as a general rule — cannot influence the long-run level of employment or unemployment. And that’s certainly correct. What we are trying to address is the short run cyclical gap.”

Philadelphia Fed President and esteemed academic Charles Plosser took an even stronger view that monetary policy was ill-equipped to reduce a 9% unemployment rate:

“You can’t change the mortgage broker into a computer expert in a manufacturing plant very easily. Eventually that stuff will sort itself out. People will be retrained and they’ll find jobs in other industries. But monetary policy can’t retrain people. Monetary policy can’t fix those problems.”

The Bernanke-Plosser debate was waged on the common ground that in the longer-run, monetary policy had virtually no relevance to the labor market — only to inflation. The only question to be debated was whether conditions could be improved in the short run.

Thankfully, current FOMC members are starting to take a more expansive view. Despite the Great Recession officially ending more than 10 years ago, the Fed can still play a supportive role in overcoming persistent sources of economic weakness. Chair Powell noted that for members of low and moderate income communities:

“They haven’t had…a bull market…a booming economy. What they have had is low unemployment, lots of social problems. And just now, you have… companies who want to hire and are…providing opportunities for people to come into the labor force to an extent not seen in quite a long time.”

The Long Run Is Shaped By The Short Run

Judging by the evolution of the FOMC’s Summary of Economic Projections, other FOMC members see this issue similarly. The estimates of the longer-run equilibrium unemployment rate appear to be sensitive to short run cyclical developments (see figure 1). According to the textbook, this equilibrium unemployment rate is supposed to be guided by factors that are independent of central bank policy. Yet if you take the Fed’s more recent set of statements at face value and observe some of the recent evidence, then it is obvious that through its short-run interventions the Fed can shape longer-run labor market outcomes.

The Fed Has Been Effective In Supporting Labor Market Progress

To the Fed’s credit, the post-crisis period has been marked by a strong bias towards easing financial conditions at moments when employment growth was falling and unemployment declines were at risk of reversing (see Figure 2). Even when constrained by the zero lower bound, the Fed was able to take actions that led to lower borrowing costs for the private sector and a more competitive exchange rate (Neely 2015).

• Just as employment and GDP growth were slowing in the latter half of 2010 amidst state and local government layoffs, the Fed was ready to support a weaker dollar and lower mortgage rates with a second round of large-scale asset purchases (LSAP 2 / QE2).
• In the latter half of 2011, when tighter fiscal policy and the European sovereign debt crisis raised the risk of a double-dip recession, the Fed stepped in with the maturity extension program (MEP / “Twist”) and stronger forward guidance.
• In 2012, ongoing fiscal austerity and the fiscal cliff forced the Fed to engage in an indefinite third round of LSAPs (QE3) and commit to the Evans Rule.
• More recently, the Fed has adjusted to headwinds from the global economy and the domestic energy sector by postponing hikes in 2016 and reversing course altogether in 2019.

Signs of stalling labor market progress were met with sufficient monetary easing to extend the expansion.

The Fed’s Reaction Function Must Move Beyond The Natural Rate Hypothesis

The Natural Rate Hypothesis centers around the idea that there exists only one unemployment rate that is consistent with stable inflation. Going below that natural rate of unemployment will ultimately prove short-lived and excess inflation will be the only lasting result. As a result, the Fed tends to be guided by policy rules that center around keeping the unemployment rate close to its estimated natural rate. However, because such estimates are highly imprecise, policy is likely to be error-prone if it is set as a direct function of the estimated natural rate.

The Fed’s over-tightening in the latter half of 2018 was in part the result of an excessive dependence on such estimates. The Fed assumed that with the unemployment rate going beyond its natural rate, higher policy rates would be needed over time in order to keep inflation under control. Instead, inflation undershot the Fed’s forecasts and estimates of the natural rate of unemployment have since moved lower in 2019. As a result, the Fed has had to reverse course and reduce interest rates after raising them throughout 2018.

It is no longer appropriate for policy to be so closely tied to the Fed’s sticky estimates of the natural rate of unemployment. The cost of repeating the mistake of 2018 is simply too high. The Fed needs to clarify and formalize a new reaction function that reflects the labor market benefits it now seeks to preserve and sustain. If it does not, the public will remain confused about the Fed’s willingness to ease while the headline unemployment rate remains low.

One way of doing so would be to aim to put a floor under gross labor income growth. Such a framework would make clear to the public that the anticipation of weak employment and wage growth would offer sufficient justification for easing. This would still be consistent with the rate cut that was delivered in July. It would also give the public more confidence that it would ease aggressively enough in response to early signs of labor market deterioration.

The Fed Should Take Responsibility For Its Role In Preserving Tight Labor Markets

The Fed deserves to take some credit for its role in sustaining the expansion despite numerous headwinds. Nonetheless, these newly recognized benefits from a long expansion and a tighter labor market raise the stakes of future policy decisions. Timely support for aggregate demand has been a necessary condition for ensuring that this expansion continued. The Fed has helped to undo damage that was previously attributed to structural causes.

Only recently has the Fed started to appreciate the full impact of its policies. The Fed’s reaction function now needs to change to reflect this reality.

In common parlance, we describe recessions as two-quarters of negative real GDP growth. Matt Klein illustrates that real GDP is actually a flawed summary variable for characterizing recessions because it ignores per capita outcomes and glorifies economies solely due to working-age population growth:

“Australia may have the record for missing recessions but it doesn’t have much of an impressive record when it comes to total growth, especially after accounting for the rapid growth of its working-age population.

This is particularly obvious when comparing how much GDP per person aged 20–64 has grown in Australia against Japan and Spain. Both Japan and Spain experienced severe recessions since 2007 and both are often considered economic examples of what to avoid (deflation, real estate busts, and banking crises). Yet Japan has grown 4% more than Australia over the past couple of decades, while Spain has grown almost as much as Australia.”

The National Bureau of Economic Research (NBER), the de facto recession authority in the United States, does not actually use a strict two-consecutive-quarter real GDP definition. It uses a variety of different indicators.

• The 2001 recession no longer fits the two-consecutive-quarter definition. Real GDP was initially reported as having contracted in the second quarter of 2001 but was later revised up sharply a few years later to show that output had actually expanded. Despite the revision, the NBER’s classification of this period as a recession remained unchanged.
• When using a variety of metrics, the methodology naturally becomes more opaque and has scope to take on new biases.

Recession definitions end up being more arbitrary than is generally appreciated. We should never lever ourselves too heavily to a single indicator or a single institution’s description.

But if I were to tie myself to a single indicator… I would probably choose the prime-age employment-to-population (PA EPOP) ratio. Labor utilization rates reflect per capita outcomes, and PA EPOP is certainly better than the headline unemployment rate. PA EPOP is also more timely and less vulnerable to revision than per capita real GDP. The challenge with using labor utilization rates is that it cannot increase forever, but the US still appears to be far from that upper bound, as other economies such as Canada quite clearly reveal

Here’s what it would look like if we flagged every month involved in two consecutive 3-month/quarterly periods of PA EPOP contraction:

Here’s what we see using the NBER definition:

What does the two-quarter change (6-month change in the 3-month moving average) look like for the prime-age employment-to-population ratio? (Keep in mind that data looks more volatile at a monthly frequency)

A few takeaways:

1. Recessions should not be treated as simply rare, sparse outcomes. The last three NBER recessions are really just the worst parts of PA EPOP downturns that last 3–5 years. These extended PA EPOP downturns are only occasionally interrupted by periods of PA EPOP expansion. Does the NBER methodology inadvertently cut policymakers too much slack?
2. The change in PA EPOP tends to be a leading indicator heading into NBER recessions but continues to decline even after the NBER recession has concluded. In the last three recessions, the underperformance of employment growth has begun many months earlier than when the NBER officially designates the starting point of a recession. The last three recessions have also resulted in jobless recoveries and extended periods when the economy was at risk of a “double-dip” recession due to the precarious state of the labor market.
3. Watch PA EPOP now. The 3-month moving average of PA EPOP is currently in a mild decline. Whether this is a blip or marks something more meaningful, we should be focusing more on the implications of slowing labor takeup. Given that aggregate compensation growth (GLI) is also slowing, this does not appear to be capacity-related slowing.

Employment-to-population (EPOP) ratios measure labor utilization more robustly than unemployment rates.

The Fed’s approach to policymaking and communication should reflect this reality. It claims to be looking at alternative measures of labor market slack, but in practice, they serve mostly as secondary and tertiary supplements.

Ahn & Hamilton (2019) highlight a core problem in the Current Population Survey (CPS), which is used for calculating the headline (U-3) unemployment rate.

• The CPS does a poor job of distinguishing between those who are not participating in the labor force and those who are participating but unemployed. This blurry distinction likely leads to persistent but time-varying underestimation of the labor force participation rate and the unemployment rate. (Figure 4)
• The CPS can more robustly distinguish between who is employed and who is not employed. As a result, EPOP ratios are a more robust starting point.

The challenge with the headline EPOP ratio is that there are acyclical demographic trends that also require adjustment.

• To adjust crudely, EPOP for prime-age cohorts (25–54) would remove the major acyclical trends related to schooling, which mostly affects those younger than 25, and retirement, which mostly affects those older than 54. More granular adjustments are also feasible using the CPS.

• Prime-age EPOP would have been a less helpful measure during much of the 1960s, 70s, and 80s due to the systematic rise in female employment.

Canada’s prime-age EPOP has been historically elevated, but accelerated pressures on wages and prices have not materialized as of yet.

Under modern macroeconomic frameworks, inflation is supposed to be largely a function of expectations, which we cannot measure directly, and the relative level of labor utilization (or the “output gap”). The simplified logic underlying this idea is that as labor grows more scarce, businesses will be more likely to raise wages and prices.

To many, the puzzle now is why we have not seen higher inflation in the presence of low unemployment. One common view is that we are not measuring “true unemployment” correctly. While PA EPOP should address most of these measurement issues, Canada shows us that even this explanation fails to hold up under closer scrutiny. We might have to acknowledge that even the best measures of labor utilization will serve as an an incomplete assessment of whether, in the context of price stability, maximum employment has been achieved.

Not only is Canada’s prime-age EPOP above the US, but it is currently at a new all-time high relative to its own history! Nevertheless, Canada has seen little in the way of sustained inflationary pressures.

We have not even seen anything resembling sustained wage acceleration either.

Time to rethink model specification!

It is easy (and virtually unfalsifiable) to claim that the rate of unemployment or prime-age employment is simply very different from what we previously assumed. Canada has pushed both measures to such an extreme and yet the conventional approach is still failing to offer useful results.

• The common answer we hear is that the Phillips Curve is so flat that inflation expectations are all that matter for determining inflation outcomes, and that labor markets have become virtually irrelevant. However, such a claim fails to explore other potential explanations for how labor markets are relevant aside from the level of labor utilization.
• For example, what if it is the change in labor utilization that matters for price stability, and not solely the level itself? If that were the case, then labor utilization would only be constrained in terms of speed, not in terms of destination. In other words, it doesn’t matter where you are on the road. It might only matter how fast you are going!
• After accounting for the lag in inflation, it appears that major segments of inflation are more correlated to the change in labor utilization than the outright level. There is more work to be done here, but if you would like some initial food for thought…

Concluding Thoughts

There are good and not-so-good reasons to focus on the prime-age employment rate. If you are trying to measure labor utilization while adjusting for the appropriate acyclical factors, the prime-age employment rate is an excellent starting point. If you’re expecting inflation to show up once a high PA EPOP ratio has been achieved, Canada’s current set of outcomes suggests otherwise.

Some in the dismal science might be disheartened to learn that Phillips Curve dynamics are even less evident in economies with historically high levels of labor utilization, but we prefer to take a more optimistic view. At least in the near- to medium-term, labor markets in the US and probably even Canada have scope to be more inclusive without triggering sustained acceleration in prices.