BUSINESS CYCLES are never perfectly symmetric across time and space. Yet they have rarely been as uneven as the rebound from covid-19. Some parts of the global economy are straining to meet roaring demand even as others are limping along, battered by the spread of the virus. It is enough to take the fun out of monetary policy. Indeed, the Delta variant kept attendees of an annual symposium for central bankers from meeting in Jackson Hole, Wyoming, in the shadow of the majestic Teton mountains. Instead, they peered at their computer screens as they discussed how to shepherd an unbalanced economy through uncertain times.
A pressing question loomed over the proceedings: just how and when to tighten policy given high inflation and lingering unemployment. Tweaks to the Federal Reserve’s framework in recent years are meant to give it room to manage such difficult circumstances. It now aims to hit its 2% inflation target on average and will court high inflation to make up for past shortfalls. But surging prices are testing this approach. Data released as the conference began showed that the Fed’s preferred measure of inflation had risen to 4.2% in July, the highest in 30 years. Jerome Powell, the Fed’s chairman, made no suggestion to his fellow participants that he would drastically change course, and confirmed that he might begin to taper asset purchases later in the year. But policy, he cautioned, would have to change as new data come in.
Research presented at the symposium offered guidance on how to cope with a lopsided recovery. Veronica Guerrieri of the University of Chicago and her co-authors, for instance, considered how policymakers should respond when demand surges in some sectors and lags in others. If there is little scope for workers to shift from unfavoured industries to the up-and-comers, they write, then the shift in demand acts like a “cost-push shock” (similar to a spike in oil prices). In such cases, central banks typically accept some pain in the form of above-normal inflation and some in above-normal unemployment. But if workers can move, then there are benefits to the central bank’s facilitating this shift.
Easy money is not obviously the right answer. If loose monetary policy raises demand for both booming and busting sectors, then it might slow reallocation by acting to prop up businesses that ought really to close. But the authors argue that, in a world in which it is easy to adjust wages upward but tricky to cut them, inflation may in fact hasten the reallocation of workers. Because nominal wages in the lagging industries cannot easily fall, workers face little incentive to move to promising industries. Inflation, though, enables the real wage in lagging sectors to fall relative to that in booming ones, encouraging workers to move. Thus it might make sense, in the context of an uneven recovery, for monetary policy to have an inflationary bias.
Clear advice for Mr Powell, then. But if American firms continue to hire at the recent pace, the unemployment rate may fall back to its pre-pandemic level of 3.5% by the end of 2022. That presents the Fed with a new dilemma. While the unemployment rate has recovered quickly, labour-force participation has not: of the drop experienced in early 2020, just under half has been clawed back; the unemployment rate, by contrast, is more than 80% of the way back. Part of Mr Powell’s justification for the change in framework was the beneficial effects of tight labour markets, which he reckoned would eventually draw disadvantaged workers back into the labour force. But the patience needed to allow such effects to unfold could vanish amid high inflation and low unemployment.
Work presented by Bart Hobijn of Arizona State University and Ayesegul Sahin of the University of Texas at Austin on the “participation cycle” reaffirms the benefits of patience. It is not the case that workers from disadvantaged groups are especially likely to drop out of the labour force during downturns and are only enticed back after sufficiently long recoveries. Rather, the probability that a worker drops out is much higher for unemployed workers than employed ones, whatever their background. It is thus the higher unemployment rates that disadvantaged groups tend to face that are responsible for their leaving the labour force. And this effect begins reversing as soon as labour markets begin to recover. Greater job stability—that is, a higher probability of finding work and a lower probability of losing a job—reduces the flow of workers into unemployment and out of the labour force, raising the participation rate over time.
The effect is powerful; the authors estimate that a one-percentage-point decline in the unemployment rate tends to raise the participation rate by 0.65 percentage points, other things equal. The beneficial effect continues even after unemployment reaches a trough, with the participation rate typically reaching a peak nine months later. The upshot for policy is therefore broadly similar to where Mr Powell has ended up: a low unemployment rate need not imply that labour-market slack has run out, or that patience on the part of the central bank will not be rewarded.
When the odds are against you
Other research reinforced the doveish conclusion. Emerging markets, participants learned, could be dealt a setback by premature monetary tightening in the rich world, which would act to push up their borrowing costs and tighten financial conditions.
Outside the conference, however, Mr Powell is being bombarded by criticism of loose money. Inflation has now more than made up its shortfall since 2015, let alone the start of the pandemic. Some heads of regional Fed banks, such as Raphael Bostic of Atlanta, are eager to reverse quantitative easing soon. Prominent economists, such as Raghuram Rajan of the University of Chicago and Larry Summers of Harvard, have highlighted the dangers of prolonging asset purchases. Discussions at the conference suggest Mr Powell’s policies will defy this growing band of critics. They are likely to remain anxious for some time yet.
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