By Robert Herren, Professor

NDSU Agribusiness and Applied Economics Department

The U.S. Constitution gives Congress the authority to conduct monetary policy. Beginning with the 1913 Federal Reserve Act, Congress has delegated this authority to the Federal Reserve (Fed). Congress has provided the Fed with a dual mandate: price stability and maximum employment.

Since January 2012, the Federal Open Market Committee (FOMC), which is the part of the Fed that determines monetary policy, has defined price stability as a 2 percent inflation rate. The FOMC acknowledges that defining maximum employment that is consistent with price stability is more difficult.

Slack in the labor market occurs when employment is less than “maximum” employment, or equivalently, when the unemployment rate is higher than its normal rate. When slack occurs in the labor market, the Federal Reserve can increase the growth rate of aggregate demand without increasing inflation. However, as the slack disappears and the labor market tightens, employers begin to offer higher wage increases to retain and attract workers. If not accompanied by increased labor productivity, the higher wage increases result in higher price inflation.

In its Jan. 27, 2015, “Statement on Longer-run Goals and Monetary Policy Strategy,” the FOMC wrote, “The maximum level of employment is largely determined by non-monetary factors that affect the structure and dynamics of the labor market. These factors may change over time. … For example, in the most recent projections, FOMC participants’ estimates of the longer-run normal rate of unemployment had a central tendency of 5.2 percent to 5.5 percent.”

Because the unemployment rate in April was 5.4 percent, one could infer from the FOMC’s projections that slack in the labor market mostly has been eliminated. In this situation, the Fed typically would raise its target for the federal funds rate to restrain growth of aggregate demand.

Yet in its April 29 meeting, the FOMC did not change its target in part because it is looking at labor market indicators in addition to the overall unemployment rate. Since December 2007, the labor force participation rate has declined from 66 to 62.8 percent (lowest since 1978).

This decline reflects retirement of the youngest baby boomers and withdrawal from the labor force of workers who have stopped looking for a job but have stated they would take a job if it became available. The latter group may re-enter the labor force when labor market conditions improve. In addition, part-time workers wanting full-time work have increased since December 2007; these workers provide additional unused labor resources.

If the FOMC is correct that slack remains in the labor market, the U.S. can continue strong employment growth even if the unemployment rate does not fall. If it is incorrect by overestimating the slack in the labor market, it will need to be more concerned about rising inflation. In this case, the FOMC may be forced to raise the target for the federal funds rate faster than most people expect.

NDSU Agriculture Communication - June 15, 2015