In a speech last week, Federal Reserve Board Chair Janet Yellen inadvertently told us why Congress should set a 4 percent unemployment target for the Fed in its conduct of monetary policy, as is proposed in a new bill put forward by Michigan Representative John Conyers. The context was Yellen's dismissal of such a target.
Yellen dismissed the idea of such a target by saying:
The maximum level of employment is something that is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. Moreover, the maximum level of employment, the longer-run 'natural' rate of unemployment, and other related aspects of the labor market are not directly observable, can change over time, and can only be estimated imprecisely.
There is much truth to this comment. Certainly the Federal Reserve Board cannot just pick any number and say it will get the unemployment rate to that level. There are limits posed by the economy that can prevent the Fed from hitting an unemployment rate target despite its best efforts.
However, this is also true of the 2.0 percent inflation target that the Fed has chosen for itself as a basis for policy over the last decade. Certainly Yellen is well aware of the fact that the inflation rate in the core personal consumption deflator targeted by the Fed has been well below its 2.0 percent target for the last six years. This is due to the fact that the Fed cannot simply set any inflation rate it likes.
To its credit, the Fed has pursued aggressive monetary policy which has the purpose of boosting demand and increasing inflation. But this effort has obviously not been sufficient to reach the 2.0 percent target even after a considerable period of time. The rate of inflation may eventually accelerate and rise back to the Fed's target, as Yellen suggested in her speech, but the long undershooting of the targeted rate shows clearly that the inflation rate is not directly under the Fed's control.
The Fed could view an unemployment target in the same way. It is a goal to strive for, with the understanding that Fed actions by themselves may not be sufficient to reach the goal, or at least not in a short period of time.
The law that governs the conduct of monetary policy in fact instructs the Fed to pursue high employment and stable prices as equal goals. The law does not tell the Fed that it should prioritize a stable inflation rate. It also says nothing about a 2.0 percent inflation target. This is a goal that the Fed has decided for itself, not a directive from Congress.
This is the reason it is appropriate for Congress to pass new legislation that explicitly sets a low unemployment rate as a target for Fed policy. In the past, and it also appears to be the case now, the Fed has decided that it would place more of a priority on the stable prices portion of its mandate, even at the risk of needlessly denying jobs to millions of people.
The 4.0 percent target was not pulled out of the air. The United States, in fact, had a 4.0 percent unemployment rate as a year-round average in 2000, following two and a half years in which the unemployment rate was less than 5.0 percent. There is little evidence of any increase in the inflation rate as a result of this prolonged period of low unemployment. The increase in bargaining power from a strong labor market did allow tens of millions of workers at the middle and the bottom of the wage ladder to achieve strong gains for the only time in the last 40 years.
This is why low unemployment matters so much. It is not just about getting people jobs, as important as that is. It is also about allowing tens of millions to be able to share in the benefits of economic growth.
For this reason, a Fed that was taking both parts of its mandate seriously would be very hesitant to raise interest rates and deliberately slow the economy in the absence of clear evidence of inflation. At this point, any honest economist has to acknowledge that we do not have a very good understanding of the dynamics of inflation. Throwing people out of work based on a theory of inflation that may not even be right seems like pretty bad policy.
In this respect, it is worth noting that most economists, including Janet Yellen, did not think the Fed should let the unemployment rate fall so low in the late 1990s. They were worried that inflation would get out of control. They were wrong.
Representative Conyers is absolutely right to put forward legislation clearly directing the Fed to take the employment part of its mandate seriously. The Fed should require solid evidence that inflation poses a threat before it tries to slow the economy. That evidence does not exist now.