Unlike many central banks, the Federal Reserve has a dual mandate to promote maximum sustainable employment with stable prices. This dual mandate has been a guide for the Fed to implement accommodative monetary policy, especially during the poor economic and financial conditions over the past six years. Unfortunately, after targeting the Federal Funds Rate at the zero lower bound, completing Operation Twist, introducing new methods of forward guidance, creating two new interest rate modification tools, and implementing three rounds of quantitative easing, America’s economy is still underperforming. In order to fulfill its mandate, the Fed needs to expand its labor market perception of underemployment, consider targeting wage growth, and look towards new measures of labor market slack.
Over the past five years, the economy has consistently undershot the Federal Reserve’s two percent targeted inflation goal. In the last 70 months, only three months have seen measures of inflation, or the Personal Consumption Expenditures (PCEPI) core price index, above the two percent mandated target. Furthermore, the Producers Price Index (PPI), a leading indicator for inflation, has remained well anchored under two percent. Even with the $3.5 trillion in large-scale asset purchases and maintaining the federal funds rate at the zero lower bound since 2008, inflationary pressures have remained absent. The Fed does not currently face a conflict in monetary policy goals between prices and the labor market.
With inflationary pressures out of the picture, the labor market has remained sluggish since the recession. In 2012, the December FOMC policy statement announced that the Committee decided that an exceptionally low range for the federal funds rate “will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent.” This new form of forward guidance was monumental; however, it became shortsighted when the unemployment threshold quickly became irrelevant when the unemployment rate plummeted below the 6-1/2 percent threshold in less than a year. While the improvements in unemployment are a positive factor, the rate fails to account for significant amount of labor underutilization remaining in the economy.
Back in 2009, the economy was losing over 700,000 jobs per month. This amounts to more jobs lost per month than the number of residents in Vermont. Since the end of the recession, the private sector has regained over nine million jobs and the unemployment rate has fallen from 10.1 percent to 5.9 percent. Despite the improvement in unemployment, further measures of underemployment suggest significant labor market slack. There are currently 7.1 million Americans who would prefer to work full-time, 2.2 million Americans who are marginally attached to the workforce, and 698,000 discouraged workers who are not searching for a job but would want work if the labor market were stronger. As Janet Yellen addressed during the September FOMC press conference, “there are still too many people who want jobs but cannot find them, too many who are working part time but would prefer full-time work, and too many who are not searching for a job.”
The Fed’s dual mandate does not only encapsulate the U-3 measure for unemployment. Instead, in order to stimulate maximum employment, the Fed needs to consider a large number of cyclical and structural factors to gauge maximum employment and labor market slack.
The Labor Force Participation rate is currently at a 36 year low at 62.7 percent. This is the lowest participation rate ever recorded for individuals between 25 – 29 years old and the lowest participation rate ever recorded for men. According to research from the Chicago Fed, the labor force participation rate is 3/4 of a percentage point below predictions based on historical projections (Aaronson et al., 2014). This disparity may indicate that there is likely an extra margin of slack in labor markets beyond the U-3 unemployment rate.
Another indicator for labor market slack is wages. Over the past few years, wage growth has remained stagnant around 2 to 2.25 percent for the private sector. This is well below pre-recession levels of 3 to 4 percent. Moreover, Aaronson and Jordan demonstrated that wages would have been almost a full percent higher in 2014 if pre-recession labor market conditions had been restored, indicating that wage stagnation is another factor contributing to labor market slack. Wage growth is a good tool to measure labor market slack since it applies to all workers, and captures both economic growth and inflationary pressures. For example, four percent nominal wage growth in an economy in the long run would account for two percent inflation along with additional economic growth upwards of two percent. Unlike unemployment, wage growth also includes pressures from underemployment, discouraged workers, and inactivity in the labor force, which influences labor supply.
Blanchflower and Posen (2014) propose that the FOMC could use wage growth as an intermediate target for the employment stabilization side of the Fed’s dual mandate. Unlike unemployment, the rate of wage inflation is subject to less distortion by such factors as inactivity and discouraged workers, while it encompasses influences of underemployment in the economy. This new perspective could be a more successful threshold the FOMC could implement in order to judge labor conditions.
However, wage targeting presents a variety of issues. For one, there are multiple measures of wage growth compiled by the Bureau of Labor Statistics. This includes average hourly earnings, the employment cost index, unit labor costs, and median weekly earnings. Furthermore, private companies like ADP also have their own measures of wage growth. The Fed would have to make a transparent and explicit definition of wage growth before considering the use of a wage benchmark. There are also concerns regarding sticky wages. Wage pressures have been demonstrated to be rigid, especially in America where employers often wait until the fourth quarter to raise wages. Olivei and Tenreyro have examined how wage rigidity in America plays a significant role in monetary policy transmission and the impacts of monetary policy shocks. Rigidity in wages poses an interesting dilemma for the FOMC if they wish to use wages as a benchmark. It would become difficult for the Fed to accurately examine wage pressures on a monthly basis, and could make monetary policy shocks more frequent if the Fed fails to interpret the appropriate level of wage pressures.
Targeting wages would be a useful tool, but continues to pose significant dilemmas in perfecting the labor market slack picture. At the Annual Jackson Hole monetary policy conference, Chair Yellen commented that the “decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions… our assessments of the degree of slack must be based on a wide range of variables.” In order to get a better sense of labor market underutilization, the Kansas City Federal Reserve has produced a Labor Markets Condition Index (LMCI). The Fed’s new index is a “dynamic factor model” that displays monthly changes in 19 labor market indicators. The Fed has just started to publish the LMCI on a monthly basis, and many economists have considered the weighted index to be a useful tool for assessing the change in labor market conditions.
In recent monthly FOMC policy statements, the Fed includes a section emphasizing that the Fed will not raise short-term interest rates “until the outlook for the labor market has improved substantially in a context of price stability.” Even though the Fed attests that LMCI captures a broader level of labor market activity than the unemployment rate, the index has a correlation of -0.96 to the unemployment rate. Basically, the index mimics movement of the unemployment rate. Although the index is designed to indicate broader measures of labor market slack, it is still highly correlated to the unemployment rate.
Recognizing these issues, I put together my own index measure of labor market slack. Looking at broad measures of labor underutilization, the index takes into account the movements of nine labor market indicators that Chair Yellen has voiced as her favorite indicators for inspecting labor market health. These indicators include the U-3 unemployment rate, U-6 underemployment rate, hires rate, quits rate, layoffs/discharges rate, job openings rate, long-term unemployment percent share of total unemployed, labor force participation rate, and average hourly earnings. Using these nine indicators of labor market conditions, I created an aggregate distance function. For example, the equation is an accumulation of distance functions, seen below:
(ac – ap/ap)^2 + (bc – bp/bp)^2 + … (nc – np/np)^2
The subscript “c” indicates current conditions, and the subscript “p” represents pre-recession averages (2005 – 2007). By comparing these measures to their pre-recession norms, we can measure remaining labor market slack. Through this index, it is clear that there is still significant labor market slack (see below).
Using an index similar to this could be a method for assessing labor market slack in order to determine the proper time to raise short-term interest rates. Regardless of the Fed’s choice in labor market indexes, many indicators point towards excessive labor market slack remaining in the economy. With inflation undershooting the two percent target, the Fed faces no conflict in goals, and can continue its accommodative monetary policy stance in order to promote employment and economic growth.