For most of the past four decades, the Federal Reserve has comported itself as a corroborating witness for deficit hawks on Capitol Hill, and a security system for anti-inflation paranoiacs on Wall Street.
In the late 1970s, stubbornly high inflation taught the central bank that the conflict between its dual objectives — to promote full employment and price stability — was fiercer than it had previously thought. Specifically, the Fed decided that it would need to preemptively cool the economy when unemployment got too low, so as to snuff out inflationary spirals before they took hold. This was because tight labor markets allowed workers to hold their employers hostage to unreasonable wage demands; with no reserve army of the unemployed to draw new hires from, bosses were forced to placate existing staff. Thus, employers ended up overpaying their workers and then trying to compensate by overcharging consumers. Workers, being consumers themselves, responded to such price hikes by extracting even higher wages from their employers, causing employers to enact even more extortionate price increases, setting off a vicious inflationary cycle. Therefore, central banks had to proactively preserve slack in the labor market — both by slowing economic growth through interest-rate hikes when unemployment got too low, and by encouraging Congress to rein in deficit spending lest it spur excessive demand for labor.
This analysis was tendentious at the time, and has become more dubious in the decades since. But the Fed’s decision to de-prioritize full employment both reflected and perpetuated a right turn in American politics that consolidated the new anti-inflationary economic orthodoxy. This would ultimately constrain the ambitions of the Clinton and Obama administrations, with the Fed pressuring the former to slash the deficit, and pursuing premature rate hikes that slowed economic recovery under the latter.
But times have changed — and so has the Fed.
Under Jerome Powell, the central bank has brought American monetary policy into belated alignment with federal law and empirical economics. Instead of attempting to preempt high inflation by sustaining a cushion of unemployment, Powell has waited for inflation to actually show itself before deliberately cooling the economy, a posture he has justified by emphasizing the myriad economic and social benefits of maximizing employment.
As a result, the Fed’s role in America’s fiscal policy debates has flipped. This week, Joe Biden’s $1.9 trillion stimulus plan took on some friendly fire from center-left economists Larry Summers and Olivier Blanchard. While both endorsed the necessity of significant stimulus spending, they suggested that Biden’s package was excessively large, and would risk “overheating” the economy — which is to say, the stimulus would risk injecting more demand into the economy than the nation can satisfy, given the size of its labor force and the productive capacity of its capital stock. And when demand outstrips supply, the result is inflation.
On Wednesday, the Fed effectively intervened in this debate on Biden’s behalf. In remarks to the Economic Club of New York, Powell argued that America’s actual unemployment rate is not 6.3 percent (as official data suggest) but 10 percent, once classification errors are accounted for; that it will take “continued support from both near-term policy and longer-run investments” to restore maximum employment; and that had the pandemic not intervened, there is “every reason to expect that the labor market could have strengthened even further without causing a worrisome increase in inflation.” That last statement is key. Not only does it suggest that Powell believes the U.S. economy can support an unemployment rate significantly below the 3.5 percent we saw in early 2020, the statement also implicitly rebukes the Congressional Budget Office’s official estimate of how much more demand the economy can accommodate without overheating. Which is significant, since Summers built his “overheating” argument around the CBO’s (historically unreliable) estimate of that figure.
Biden’s chief of staff wasted little time in touting Powell’s de facto endorsement of the Biden plan.
Powell’s remarks were significant for reasons beyond their immediate political implications. For one thing, the Fed chairman explicitly disavowed the central bank’s past habit of raising interest rates for the sole purpose of keeping a sufficient number of Americans unemployed. “Recognizing the economy’s ability to sustain a robust job market without causing an unwanted increase in inflation,” Powell said, “we will not tighten monetary policy solely in response to a strong labor market.” What’s more, he clarified that — since the central bank has repeatedly undershot its 2 percent inflation target — it will now aim “to achieve inflation moderately above 2 percent for some time in the service of keeping inflation expectations well anchored at our 2 percent longer-run goal.” In other words: Congress won’t have to worry about fiscal stimulus triggering higher interest rates until inflation remains above 2 percent for an extended period of time, which gives lawmakers far more room to maneuver than if the Fed treated 2 percent as a ceiling rather than a targeted average.
Perhaps most significantly, Powell broke with past Fed chairman Ben Bernanke by arguing that fiscal and monetary stimulus doesn’t just accelerate an economy’s return to full productive capacity, but rather, that stimulus can actually grow the economy’s long-term growth potential. Powell argued that strong labor-market conditions can heal “entrenched damage inflicted by past recessions,” while also expanding the size of America’s labor force (and thus, its productive potential). Here’s the key passage:
The labor force participation rate … had been steadily declining from 2008 to 2015 even as the recovery from the Global Financial Crisis unfolded. In fact, in 2015, prime-age labor force participation—which I focus on because it is not significantly affected by the aging of the population — reached its lowest level in 30 years even as the unemployment rate declined to a relatively low 5 percent. Also concerning was that much of the decline in participation up to that point had been concentrated in the population without a college degree. At the time, many forecasters worried that globalization and technological change might have permanently reduced job opportunities for these individuals, and that, as a result, there might be limited scope for participation to recover.
Fortunately, the participation rate after 2015 consistently outperformed expectations, and by the beginning of 2020, the prime-age participation rate had fully reversed its decline from the 2008-to-2015 period. Moreover, gains in participation were concentrated among people without a college degree.
In other words: By facilitating tight labor markets, low interest rates and high deficit spending did not cause demand to outstrip supply; rather, they expanded the supply of labor by generating employment opportunities sufficiently appealing to attract discouraged workers off the economy’s sidelines. It isn’t difficult to imagine how this would happen. For example, if you are a partially disabled worker living in a country with loose labor markets, you may have a hard time finding an employer who is willing to make the accommodations necessary for you to contribute your skills to production. But under tight labor-market conditions, employers will have sufficient incentive to help you comfortably participate in the economy.
The Federal Reserve’s authority over monetary policy — and technocratic credibility on questions of spending — gives it considerable power to shape the economic paradigm within which democratic politics operates. In the late 1970s, the central bank used this power to consolidate a reactionary turn in American economic policymaking. In 2021 — under the leadership of a Trump-appointed, Republican investment banker — it is doing its darnedest to consolidate a progressive one.
