The most inclusive recovery in US history is being pursued by the Federal Reserve. A group of top economists said in a February paper that the US could be in a new recession because of the way it is going about it.
The Fed unveiled a new policy framework five months after the US was hit by the Pandemic. The 2% inflation target and full employment goals were gone.
The central bank now pursues inflation that averages 2% over time, meaning that if the inflation dips below that threshold, the central bank can allow higher inflation to balance things out.
The Federal Open Market Committee described the Fed's labor-market target as "broad-based and inclusive", which is different from its previous full-employment target.
The chief global economists of Bank of America,Deutsche Bank, and Morgan Stanley, as well as economists at the University of Chicago and the University of Wisconsin, said in a recent paper that the new playbook might be a mistake. The team found that balancing maximum employment and stable prices would be difficult without serious risk.
The team said that letting inflation run hot helps close the gaps between the two worker groups, but it doesn't attract more advantaged groups into the labor market. That may be a big problem for the recovery, as labor-force participation remains well below precrisis levels. The labor shortage has been caused by the slow return of workers and has left businesses struggling to rehire.
The researchers said that the improvement can be quickly undone in a severe recession. They said that the risk of a downturn was mitigated by the Fed's loose monetary policy. The central bank has less policy to aid the country during a downturn since its interest rate is already zero.
The economists said that cooling inflation in a hot economy leaves the Fed with a very difficult tradeoff. Since inflation and unemployment have an inverse relationship, the Fed's efforts to ease price growth by quickly raising interest rates would require a substantial increase in the unemployment rate and some backpedaling of the inclusive recovery.
A simple back of the envelope calculation from the team shows how the Fed may chip away at its own progress towards maximum employment. The economists said that in pre-pandemic labor markets with high and rising unemployment, the average unemployment rate for less-advantaged workers rose more quickly than that for more-advantaged Americans. In a recession where the unemployment rate rose by 3 percentage points, the unemployment rate for advantaged Americans would go up and the unemployment rate for less advantaged Americans would go down.
The team said that the Fed could keep the labor-market recovery intact by keeping interest rates low. The Fed painted itself into a corner by running the economy hot for so long.
The team said that either outcome is fraught with political risk.
When the Fed meets in March, it's likely to start its rate-hike cycle. The size of its first hike is not known. With unemployment near a record low and inflation at four-decade highs, the central bank could be staring down a difficult tradeoff.
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