The Federal Reserve’s Commitment to Employment is Set for a Crucial Test
WASHINGTON — Four years after Federal Reserve Chair Jerome Powell emphasized the importance of reducing unemployment during the COVID-19 pandemic, this commitment is now being tested. Joblessness is rising, inflation appears to be under control, and the benchmark interest rate is still at its highest level in 25 years.
High interest rates may soon decrease, with the U.S. central bank anticipated to announce its first rate cut at the meeting scheduled for September 17-18. Powell might share more details about this potential shift in policy during his speech at the Kansas City Fed’s annual conference in Jackson Hole, Wyoming, this Friday.
However, after over a year of keeping the Fed’s policy rate in the 5.25%-5.50% range, the prolonged high borrowing costs might be gradually impacting the economy. Even if the central bank begins to lower rates, it may take time for the effects to manifest, which could jeopardize hopes for a “soft landing” marked by stable inflation and low unemployment rates.
“Powell indicates that the labor market is stabilizing,” with slower wage growth, a healthy number of job openings, and unemployment around what officials believe is compatible with maintaining inflation at the Fed’s 2% target, stated former Chicago Fed President Charles Evans. “That would be wonderful if it were the whole story. However, historical patterns suggest otherwise.”
Indeed, periods of rising unemployment, like those noted recently, often lead to further increases.
“The current situation doesn’t appear to indicate that. However, you could be just one or two disappointing employment reports away” from needing to make significant rate cuts to address increasing joblessness, Evans noted. “Waiting too long could complicate the necessary adjustments.”
Balancing Inflation and Employment
Evans played a significant role in reshaping the Fed’s policy direction, which Powell unveiled during the pandemic’s height at the Jackson Hole conference in August 2020, when unemployment stood at 8.4%—down from 14.8% in April.
This change in the Fed’s approach made sense in this context, shifting from a long-held focus on curbing inflation to avoiding unnecessary harms to the job market.
Traditionally, economic policy viewed inflation and unemployment as inversely related: Low unemployment would push wages and prices higher, while weak inflation indicated a stagnant job market. After the recession of 2007-2009, policymakers reconsidered this relationship and decided that they did not need to regard low unemployment as an inflation threat.
Focusing on equity for those at the edges of the job market and achieving optimal overall outcomes, the new strategy indicated that Fed policies would “be guided by evaluations of employment shortfalls from its maximum level.”
“This modification might seem subtle,” Powell stated at the 2020 conference. “Yet, it signifies our belief that a healthy job market can be maintained without triggering inflation.”
The inflation spike driven by the pandemic, coupled with a rapid job recovery, made this adjustment seem less relevant; the Fed needed to increase rates to control inflation. Until recently, inflation had slowed down without significantly harming the job market, with unemployment below 4% for more than two years, a record not seen since the 1960s. Over the past 75 years, the average unemployment rate has been 5.7%.
The events of the past two years, along with an impending Fed strategy review, have sparked numerous studies analyzing the reasons behind the decline in inflation, the influence of policy, and how approaches might change if inflation risks resurface.
Although the agenda for this year’s conference has not been disclosed, its overarching theme examines how monetary policy impacts the economy. This will inform how officials may assess future decisions and trade-offs and the prudence of measures like proactively countering inflation.
Some findings are already emerging from Fed researchers, including leading economist Michael Kiley. He has authored a paper exploring whether “asymmetry” in policy—treating employment deficiencies differently than a robust labor market—truly offers benefits. Another recent publication suggests that policymakers who view public inflation expectations as short-term and volatile should respond more swiftly and raise rates more significantly.
The influence of public expectations on inflation—and the corresponding policy measures—was prominently displayed in 2022. When there were concerns that expectations might rise, the Fed swiftly ramped up its tightening policy with consecutive 75-basis-point hikes. Powell subsequently used a shorter speech at Jackson Hole to reaffirm his determination to combat inflation—a marked shift from his previous focus on job creation just two years earlier.
This decisive action showcased the U.S. central bank’s seriousness, bolstered its credibility with the public and markets, and restored some of the reputation for proactive policies that had diminished.
Concerning Unemployment Rates
Powell is now challenged with the opposite scenario. Inflation is on the path back to 2%, but the unemployment rate has climbed to 4.3%, which is an increase of eight-tenths of a percentage point since July 2023.
There are discussions about what this signifies for the labor market in relation to the surge in labor supply, which could be a positive if new job seekers find work.
Nevertheless, this situation crossed a commonly referenced recession alert threshold, which has been somewhat downplayed due to other indicators pointing to economic growth, but it is also slightly above the 4.2% mark that Fed officials see as indicative of full employment.
The current unemployment rate is now higher than it was during Jerome Powell’s tenure as chairman of the Federal Reserve before the pandemic—back in February 2018, it stood at 4.1% and was on a downward trend.
This indicates that the “employment shortfall” he aimed to address four years ago may already be starting to manifest.
Despite this, Powell is likely to be cautious about declaring an end to inflation concerns, fearing a potential overreaction. Ed Al-Hussainy, a senior rates strategist at Columbia Threadneedle Investments, suggests that it is time for the Fed to proactively address the risk to job losses—another form of preemptive action.
Al-Hussainy noted that the Fed has demonstrated its ability to manage public inflation expectations, which is a crucial benefit, but this has simultaneously created some risks for employment.
“The current policy is misaligned—it is too restrictive—and it needs to be addressed,” he stated.
Reported by Howard Schneider; Edited by Dan Burns and Paul Simao