The Federal Reserve Wonders What "Maximum Employment" Means
The latest forecasts of inflation, unemployment, and interest rates under "appropriate monetary policy" reveal some intriguing disagreements.
The Federal Reserve has three hurdles that must be cleared before it starts raising short-term interest rates:
The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.
—September 22, 2021 Federal Open Market Committee (FOMC) policy statement
The Fed first inserted that language just over a year ago and has been publishing after every policy meeting since. Those three hurdles were established to avoid prematurely stamping out the post-Covid recovery. At the time, inflation was weak, the inflation outlook was weak, and payroll employment was running 10 million jobs below the level in February, 2020.
The inflation situation has changed a bit since then, which means that two of the three hurdles have already been cleared. That’s one reason why shorter-term interest rates have moved up since the start of 2021 and remain elevated compared to last year.
But while the job market has made a lot of progress thanks to mass vaccination and thanks to multiple rounds of income support payments from the federal government, we’re still a ways off from any reasonable interpretation of “maximum employment.”
The question is: just how far are we, and how will anyone know when we get there?
The answer matters for anyone pondering the timing and the path of any eventual increases in short-term interest rates. Unfortunately, we don’t have much guidance on how to think about the question, likely because Fed officials themselves either don’t know or can’t agree.
When the Fed first announced its new monetary policy strategy last August, officials avoided the question by being deliberately ambiguous about what “maximum employment” means:
The maximum level of employment is a broad-based and inclusive goal that is not directly measurable and changes over time owing largely to nonmonetary factors that affect the structure and dynamics of the labor market. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee’s policy decisions must be informed by assessments of the shortfalls of employment from its maximum level, recognizing that such assessments are necessarily uncertain and subject to revision.
This ambiguity makes it difficult to understand how Fed officials are thinking about the state of the economy and the appropriate stance of policy. Every quarter, the Fed publishes projections for interest rates, growth, inflation, and unemployment “under appropriate monetary policy.” These aren’t forecasts in the traditional sense, but aspirational statements of what Fed officials want to see happen.
The latest batch show that 9 of the Fed’s 18 sitting officials1 want to begin raising rates before the end of 2022, with all but one official expecting to raise rates before the end of 2023 “under appropriate monetary policy”.
While we can’t match the individual interest rate projections to each FOMC member’s aspirational projections of growth, inflation, and unemployment, we can roughly estimate what the FOMC as a whole is thinking about “maximum employment” by comparing the numbers above to the projections for the jobless rate. For context, the official jobless rate was 3.5% on the eve of the pandemic—although there’s a strong case that the U.S. was far from “maximum employment” even back then.
As of now, just 4 of 18 FOMC members think the jobless rate will be 3.5% or lower by the end of 2022. But there are 9 people on the FOMC who ostensibly believe2 that the “maximum employment” hurdle will be cleared by the end of 2022. That suggests that the FOMC has 4 optimists who want to raise rates because they expect a rapid jobs recovery, plus another 5 officials who think that the U.S. job market was permanently damaged by the pandemic and/or that the jobless rate was “too low” back in January and February 2020.
Of the other 9 FOMC members, all but one thinks that rates should start to rise by the end of 2023, which suggests that 8 members think that the employment hurdle will be cleared during that year. As it happens, there are 12 officials who think the jobless rate would be at or below 3.5% “under appropriate monetary policy” by the end of 2023, which is 8 more than the 4 officials who project that outcome by the end of 2022. While most of those 8 probably think that “maximum employment” is right around 3.5%, some may be among those who think the jobless rate could dip below 3%.
Perhaps the most intriguing nugget is the new outlook for the end of 2024. Under “appropriate monetary policy” the jobless rate edges lower even though everyone is pencilling in interest rate increases. That suggests most officials want to push somewhat “beyond maximum employment” even as they plan to tighten policy in response to the economy’s underlying strength.
That’s also consistent with the inflation projections, with most officials aiming for prices to rise slightly faster than 2% a year in 2022-2024.3 Fed officials are willing to tolerate a bit more inflation in exchange for pushing the (perceived) limit on employment.
It’s worth noting that even with the recent “hawkish” shift in the interest rate outlook, the median Fed official is now expecting that the U.S. economy at the end of 2024 will be 2.3% bigger than had been expected on the eve of the pandemic, with the price level also about 2.3% higher.
Some of this optimism likely reflects the belief that pandemic-driven efficiency gains will allow businesses to produce more good and services with the same set of inputs. But some of the optimism may also reflect Fed officials’ desire to err on the side of growth.
Looking ahead, the question is whether the Fed’s actions will match these aspirations. That will depend on whether officials get two things right: their estimate of “maximum employment” and their estimate of the economy’s underlying ability to withstand a given level of interest rates without keeling over.
As it happens, their recent framework review was motivated by their track record of consistently underestimating how many jobs could be added and overestimating how high interest rates could go without generating problems. While the latest set of unemployment and interest rate projections aren’t particularly encouraging on this score, there are reasons to hope they’ve internalized—or will soon internalize—the right lessons. We’ll just have to wait and see.
There are theoretically supposed to be 19 people on the FOMC: the 7 governors on the Board in D.C. plus the 12 presidents of the regional reserve banks. But the Board rarely operates at full capacity because nominating and confirming people to fill empty slots hasn’t been much of a priority for anyone in the White House since GWB.
It’s possible that some officials believe that they can ignore the “maximum employment” hurdle entirely because the language is vague.
Five officials think yearly inflation will come in at 2% or slower in 2022-2023, presumably due the reversal of the temporary factors that have hit this year, while 8 officials expect inflation to be back to 2% by 2024 “under appropriate monetary policy.”