But would this type of slowdown be enough to bring inflation under control? Monetary policy can dampen demand growth—somewhat uncertainly and with a lag. How this demand resolves into changes in output, employment, and prices is beyond the Fed’s reach. The central bank’s choices come down to this: does it try to dampen demand gradually (which risks letting high inflation take hold) or abruptly (which risks a severe recession and much higher unemployment) ? There is no finer control than this.
Despite two quarters of declining output and what many commentators view as a hawkish shift in monetary policy, the Fed has so far opted for gradualism. The Fed funds rate is now between 2.25% and 2.5%. With consumer price inflation of 9.1% in the year to June and core PCE inflation of 4.4% in the second quarter, the policy rate is still significantly negative in real terms. By that standard, at least, monetary policy is still loose – just not as loose as it was in the spring of this year. Powell said he and his colleagues expected further rate increases to be “appropriate,” but he was notably much more vague than before.
This vagueness means that the Fed has taken a big step forward, moving from “forward guidance” on interest rates to “let’s see what happens”. Amid great uncertainty about the true state of the economy, that’s wise. Even then, it would be useful for the Fed to say more about its intentions not for the path of interest rates but for the path of demand. In particular, he should be more open about whether bad jobless news combined with bad inflation news would push him toward more or less gradualism.
Powell said he hoped a slowdown in demand could reduce pressure on the labor market without increasing unemployment. This is not fanciful, as the level of vacancies – and, in particular, the ratio of vacancies to the number of people looking for work – is currently off the charts. It is plausible to think that this is driving up wages and risks entrenching high inflation. You would think that weaker demand could reduce the number of vacancies and reduce this pressure without more people losing their jobs.
The problem is that it never seems to work that way. A new paper by Olivier Blanchard, Alex Domash and Larry Summers for the Peterson Institute for International Economics shows that historically, whenever job vacancies drop significantly, unemployment rises. By digging into the reasons, the study underlines the importance of the process which associates the unemployed with the vacancies. Improving the efficiency of this matching process may indeed reduce the number of vacancies at a given level of unemployment, but there is no evidence in the data that this is happening.
In fact, it’s worse than that. During the pandemic, the so-called matching efficiency has dropped sharply (as one might expect, with workers moving more than usual between job types and from location to location). It remains well below that of 2019. The implication is that a higher unemployment rate will be needed to keep inflation constant. Before the pandemic, according to the study, this so-called natural unemployment rate was probably around 3.6%, equivalent to the current rate. It is now 4.9%, according to a conservative estimate. If this is correct, the Fed cannot expect unemployment to remain stable because it drives down inflation.
The new GDP figures show that demand – measured in terms of output in current dollars – rose 7.8% year on year in the second quarter, after rising 6.6% in the first quarter. These figures are still too high and point in the wrong direction. This justifies the latest interest rate hike. Depending on what happens next, it may take more. In any case, as it continues to restrain demand, the Fed should expect – and should not be deterred by – rising unemployment.
More from Bloomberg Opinion:
• Are interest rates neutral? Markets hope so: Mohamed A. El-Erian
• Do you think the Fed hasn’t done enough? Think Again: Nir Kaissar
• The Beast of Inflation will no longer sit still: Allison Schrager
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Clive Crook is a Bloomberg Opinion columnist and editorial board member covering the economy. Previously, he was associate editor of The Economist and chief Washington commentator for the Financial Times.
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