The Federal Reserve and Shared Prosperity

Why Working Families Need a Fed that Works for Them

by Thomas Palley

Excerpted from the Economic Policy Institute (EPI) February Report. Read the full report here, Reprinted with permission.

The Federal Reserve’s policies affect almost every important aspect of the economy. Given the gradual strengthening of the economy after the Great Recession, there is now talk of normalizing monetary policy and raising interest rates. That conversation is important, but it is also too narrow and keeps policy locked into a failed status quo.

There is need for a larger conversation regarding the entire framework for monetary policy and how central banks can contribute to shared prosperity. It is doubtful the United States can achieve shared prosperity without the policy cooperation of the Fed. This makes activist engagement with the Fed and its policies a matter of the highest importance.

Full employment, shared prosperity, and the Federal Reserve

Full employment is the bedrock of shared prosperity. Working families need jobs to provide income, and full employment ensures that jobs are available for all. Full employment also creates an environment of labor scarcity in which workers can bargain for a fair share of productivity gains, making full employment essential for decent wages. A major factor behind the wage stagnation of the past 30 years is that the U.S. economy has been far from full employment for most of this time.

Full employment is also relevant for union bargaining power, and unions are unlikely to achieve their principal institutional objectives—organizing and bargaining—without full employment. Consequently, full employment should be a major concern of unions for reasons of both social solidarity and institutional interest.

Federal Reserve policy is absolutely critical for attainment of full employment, and the Fed is legally mandated to pursue policies that promote maximum employment with price stability. However, it has not been doing so for the past 35 years, preferring to emphasize price stability (i.e., inflation) on grounds that full employment will take care of itself if inflation is low and stable.

The Fed’s retreat from full employment has been part of a general retreat by the Washington policy establishment, including both Republicans and elite Democrats who control the Democratic Party. The labor movement and working-family activists must wholeheartedly embrace the issue of full employment and compel both Washington and the Fed to make it the nation’s foremost economic priority.

There is an irony to the current moment. Even though the Fed has failed in the past to live up to its obligations, it is now the only major Washington policy institution that is even tipping its hat to the issue of full employment. Though the Fed should be credited for its new awareness, it is critical not to forget its past inclinations. Those inclinations remain very much alive within the institution and ready to surface.

Labor and working-family activists need a strategy to ensure the Fed’s renewed concern with full employment is translated into policies that deliver. The strategy should have an inside and outside dimension. The inside dimension entails constructive informed engagement at a senior level within the Federal Reserve System. The outside dimension requires bringing popular pressure from Main Street to Congress to bear on the Fed.

The strategy must also go beyond the Fed and into the Democratic Party, which must also come to view full employment as the country’s most important economic policy priority. Democrats must be stripped of the “Clinton fig leaf” of the 1990s. In the late 1990s the United States experienced a brief period of full employment during which wages rose. That period clearly showed the benefits of full employment, but it was bubble-driven and unsustainable.

The goal is to insist on sustainable full employment supported by rising wages and real investment. The Clinton fig leaf is a major obstacle because many Democrats invoke the period to justify a return to past policies, despite their having proved unstable and unsustainable.

Policy challenges and threats

Convincing the Fed to adopt full employment policies requires persuading it to change its policy framework. In the meantime, there is an omnipresent danger that the Fed will prematurely tighten monetary policy in the name of preventing inflation, despite the fact the economy is far away from full employment. To lay the foundation for full employment, the Fed should adhere to the following precepts:

  • Rehabilitate full employment as the country’s foremost policy priority
    The central policy challenge is to rehabilitate full employment as the preeminent policy priority. That raises the question of defining full employment. Paraphrasing Supreme Court Justice Potter Stewart, full employment is difficult to define, but you know it when you see it. Full employment is likely attained when the unemployment rate is low, job vacancies are plentiful so workers can find jobs easily, the inflation rate is around 3 percent, and real wages are rising at the rate of productivity growth. For the United States, such a configuration of outcomes is associated with unemployment rates below 5 percent. That happened in 2007 and the late 1990s, and before that in the early 1970s, which shows how rare full employment has been—and how far away it still is.
  • Abandon the 2 percent inflation target
    A second policy challenge is to get the Fed to abandon its 2 percent inflation target. A large multi-sector economy is likely to have inflation above 2 percent at full employment because of differences in conditions across sectors. The 2 percent inflation target represents a cruel trap. As the unemployment rate comes down, the economy will inevitably bump against the self-imposed inflation ceiling, which likely coincides with an unemployment rate around 5.5 percent. Given its inflation target, the Federal Reserve will then have reason to pull the trigger and raise interest rates to slow the economy, thereby trapping millions in unemployment and ensuring continued wage stagnation.
  • Stop the war on wages
    A third policy challenge is to get the Fed to abandon its de facto war on wages, which is reflected in the Fed’s shortchanging of full employment and its adoption of a 2 percent inflation target. The war on wages rests on a faulty understanding that portrays wages as just a cost to the economy. The reality is wages are the principal purpose of the economy, which is to generate a decent standard of living for all. Rising wages are also needed to make the economy work. Economies where wages lag productivity growth are marked by higher income inequality. They are also prone to demand shortfalls, which cause economic stagnation as demand fails to keep pace with supply. That is the principal cause of the current economic malaise. The Fed must abandon its focus on the employment cost index (ECI), which gives monetary policy an anti-wage tilt by encouraging the Fed to raise interest rates whenever wage growth accelerates. Because the share of corporate income accounted for by profits is at a record high, it is possible wages can rise for quite a while without inflation if firms are forced to accept profit margin compression as the bargaining power pendulum swings back toward workers.
  • Resist calls for preemptive interest rate hikes to prevent inflation
    An omnipresent policy threat is the push by inflation hawks to raise interest rates as a preemptive strike against future inflation. The reality is economists do not know when inflation will accelerate, but preemptively raising interest rates increases the likelihood that the economy will stop short of full employment. That will strangle wage growth, entrench income inequality, and impose hardship on millions of working families. Instead, the Fed should adopt a “test the waters” approach to policy that allows the economy to edge forward until inflation is seen to reach an unacceptable level. That will enable the economy to reach full employment and wages to grow.
  • Do not underestimate unemployment and labor market slack
    A second threat is the Fed may underestimate the degree of unemployment and labor market slack and use its underestimate to justify raising interest rates. One danger is the Fed may misunderstand the huge numbers of workers who have left the labor force because of poor job prospects, and mistakenly think this labor force exit is permanent. A second danger is that the Fed may mistakenly see the increase in long-term unemployment as permanent and view these workers as unemployable, thereby justifying the view that labor markets are tighter than reported. The fact is the long-term unemployment rate has been steadily coming down with job growth, which shows these workers take jobs when jobs are available. The sensible thing to do is continue with job-friendly monetary policy and see if the unemployment rate continues coming down. That is the logic of a “testing the waters” approach.
  • Restore quantitative monetary policy
    In addition to changing its policy framework, the Federal Reserve must also change its policy toolbox. Today, monetary policy is largely viewed through the lens of setting interest rates. Interest rate policy is a blunderbuss that hits the whole economy, with particularly strong effects on the manufacturing sector. Policymakers need other tools that can finely target particular problem areas (such as asset price bubbles) without inflicting collateral damage on the rest of the economy. Successful monetary policy requires quantitative policy instruments such as margin requirements, reserve requirements, and regulation. Such policy tools have been largely discarded owing to the neoliberal takeover of economic policy. That has made managing the economy more difficult. It is time for the Federal Reserve to revive the use of margin requirements and introduce new policy tools such as asset based reserve requirements (ABRR).
  • Reform exchange rate policy
    Another area where change is needed is exchange rate policy. Exchange rates have an enormous impact on the economy via their impact on the trade deficit and the manufacturing sector, and that impact has increased with globalization. Exchange rate policy is formally controlled by the Treasury, but the Fed is also deeply implicated. For the past 25 years the Treasury has done an awful job with exchange rate policy, which has been managed on behalf of multinational corporations and financial-sector interests, with little regard for the impact on working families. The existing policy setup has created a Kabuki theatre that allows the pretense that the Fed, the Treasury, and exchange rates are unconnected. Given its awful performance, Congress should consider stripping the Treasury of its responsibility for exchange rate policy and moving responsibility to the Fed with strict congressional accountability attached. Exchange rates and interest rates are joined at the hip, and policy should be properly coordinated. In the meantime, exchange rate concerns should be raised with the Fed by asking how the Fed factors exchange rates into its interest rate setting, and how it takes account of the impact of interest rates on the exchange rate.
  • Finance public infrastructure investment
    The Fed should also be permitted to help finance public infrastructure investments. Such financing of infrastructure investment would raise growth by relaxing the financing constraint that currently unduly restricts such investment. One possibility is this could be done by creating a national infrastructure bank whose bonds the Fed could purchase. A second possibility is that a new federal agency, similar to Fannie Mae, could be created to securitize state and local government infrastructure bonds, and the Fed could then buy those securitized bonds.

    The 2 percent inflation target represents a cruel trap. As the unemployment rate comes down, the economy will inevitably bump against the self-imposed inflation ceiling, which likely coincides with an unemployment rate around 5.5 percent

    Read the full report here.